Choosing Between Deferred and Immediate Annuities

Like all annuities, a deferred annuity represents a contract between an insurance company and an investor. In exchange for providing the insurance company with the premium, the insurance company agrees to pay the investor a specified amount of money at some point in the future. Taxes, earnings and the distribution of payments by the insurance company are deferred until the annuitant “annuitizes” the contract, usually after age 59 ½ or at retirement. Payouts taken before age 59 ½ are subject to a 10% penalty and are taxed at ordinary income tax rates.

There are two parts to a deferred annuity: The accumulation phase and the distribution phase.

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The Accumulation Phase

The accumulation of principle can be spread out over a number of years, sometimes for decades. Some people have the option of investing in a deferred annuity via a 401(k) program through an employer. Others choose to purchase a deferred annuity directly through the insurance company. In either case, premium payments are credited to the account along with interest earned.

The Distribution Phase

The distribution phase of a deferred annuity is also known as the payout phase. The amount of the payments, and whether they continue for the life of the annuitant or for a specific period of time, are specified in the contract at the time it is written. The owner of the annuity can also choose between monthly, quarterly or annual payouts. Options are also available for the owner to ensure that his or her surviving spouse receives payments after his or her death. While a joint or survivor annuity usually pays less during the payout phase because it covers two people, it can provide lifetime financial security for both.

There are four kinds of deferred annuities. Each has a different method for crediting interest. A fixed deferred annuity pays a set amount of interest. This amount may change each year as market conditions fluctuate, but a fixed annuity can usually be surrendered without penalty if the rate that is earned drops significantly below the initial contract rate.

A variable deferred annuity pays a rate of return that is earned by investments the annuitant instructs the insurance company to make on his or her behalf. Variable annuities have a higher risk factor than fixed annuities, but the rate of return can be greater. Over time, the difference in interest accrued can be significant.

An indexed annuity derives its gains from an underlying market index. The Standard and Poor’s 500 (S&P 500) is the index most commonly used. For an investor looking for long-term growth with the potential for taking part in an ever-growing stock market, a variable deferred annuity presents a good choice.

Finally, a CD deferred annuity features many of the same features as a bank-issued certificate of deposit. The return is fixed, and over time, the CD annuity has the potential for expanded compounded growth. It is important to note, however, that unlike a CD, a deferred CD annuity is not FDIC insured.

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Why Choose a Deferred Annuity

Tax-deferred annuities grow tax-free until the annuitant begins receiving the proceeds. Therefore, deferred annuities can be a good way to supplement retirement savings. Even if the money used to purchase a deferred annuity is comprised of post-tax dollars, the interest and earnings are not taxed until payouts begin. For those who have maxed out their 401(k), SEP IRA or other retirement plans, a deferred annuity represents a way to create a self-directed pension plan.

What is an Immediate Annuity

Unlike a deferred annuity, an immediate annuity must be purchased with one lump-sum premium. The payouts made by the insurance company are not deferred. Rather, they begin immediately, most often within 12 months of the start of the contract. Further, there is no accumulation phase like there is with a deferred annuity.

An immediate annuity can have a fixed rate of return or a variable rate of return. However, the most common type of immediate annuity is fixed. This not only protects the investment from losses incurred in the stock market, but also guarantees the amount of the payout. Investors can then accurately estimate the amount of payout they will actually need to pay the expenses they are looking to cover.

Immediate annuities can also be purchased with guaranteed payments made to a surviving spouse when the contract owner dies. Some insurance companies also offer a type of immediate annuity premium refund if the contract owner dies before the full amount of the premium has been returned. For example, if a husband purchases a $250,000 immediate annuity and has only received $150,000 back in payouts at the time of his death, his wife or other beneficiary could receive the premium balance of $100,000. This “safety feature” guarantees that money is not lost when purchasing an immediate fixed annuity. The payouts on this type of policy will be less than a traditional policy, but investors may feel more comfortable knowing they will not lose money.

Why Choose an Immediate Annuity

Investors looking for a guaranteed income stream often look to an immediate annuity. A large portion of the payouts from a fixed immediate annuity is tax-free under federal and state tax laws. (Investors are always advised to discuss the tax consequences of any annuity with a professional tax advisor.)

Immediate annuities can be purchased with any type of money. While a deferred annuity must be purchased with earned income, an immediate annuity can be purchased with the proceeds from the sale of a house or an inheritance.

An immediate annuity can also protect an investor from significant market risk. Unlike other investment options like stocks and bonds, the payouts on an immediate fixed annuity are guaranteed and do not move up and down with the market. An investor can also protect his or her annuity investment by purchasing a COLA (cost of living adjustment) rider. The COLA rider will ensure that payouts rise each year in order to offset the purchasing power erosion effect of inflation.

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