What You Should Know About Deferred Annuities

Jan 9, 2014 12:22:51 PM / by Jason Shaw

deferred annuities

Like an immediate annuity, the purpose of a deferred annuity is to provide an income stream in retirement.  It can have either fixed or variable returns, and it can offer a variety of term options, including life, joint life, a predetermined period of years, or a hybrid of these.  Deferred annuities can be part of a sound investment strategy, but one should invest in them only after understanding the precise costs and benefits of doing so.  An independent, qualified investment planning professional can help you understand how these annuities might fit into your overall strategy.

Deferred vs. Immediate Annuity

A deferred annuity differs from an immediate annuity in a couple of key ways.  First, whereas you must purchase an immediate annuity with a lump sum of money, you can often build a deferred account over time, giving you more of a chance to grow your retirement income before you begin to make withdrawals.

Secondly, with an immediate annuity, you give up access to the principal as soon as you make the purchase.  When you buy a deferred annuity, however, you can continue to have some access to your money until you convert the annuity to an income stream.  Many deferred annuities have features that allow withdrawal of up to 10% annually.  Be careful with early withdrawals, however.  Deferred annuities can carry heavy surrender fees that apply to withdrawals before the account has been open for a set period of years, often 5-10 or more.  Additionally, the IRS imposes a 10% tax penalty on withdrawals prior to age 59 ½.  If you think you may need access to your money before this time, consider other investments that allow for greater liquidity.

Taxes on Annuities

Any funds that you contribute to an annuity can grow tax-deferred until you withdraw them.  This is an attractive feature for many investors, but the tax treatment of annuities is not as favorable as some other types of retirement investments.

The primary factor that makes annuities less tax-favorable than they may seem is the fact that withdrawals of gain from an annuity are taxed at the account holder’s regular income tax rate, which can be 10-20% higher than the capital gains rate.  If you hold the annuity for a long enough period, then the compounded effect of tax deferral may be sufficient to overcome the cost of the higher tax rate.  Speak to your financial professional to ensure that your investment strategy avoids any unnecessary increase in your tax obligation.

For this reason, annuities are not advisable for those who have not yet made their maximum contributions to more tax-favorable accounts, such as 401(k)s and IRAs.  Another situation that makes deferred annuities more appealing is having unearned income that you wish to invest.  Annuities provide a way for unearned income to grow tax-deferred.

Annuity Fees

As with all financial products, be wary of fees and hidden costs.  Insurance companies pay good commissions for annuity sales.  If you intend to buy an annuity, speak to an independent financial professional to get an unbiased perspective and potentially reduce costs.  Look carefully at any riders to the annuity to determine whether the benefit you expect to get out of them justifies their cost.  Be aware that the cost of a variable annuity will include a management fee for the investments it contains. Other fees may include mortality expenses (to guarantee that the fund will pay your heirs at least what has been put into it in case of your death), administrative fees, and surrender charges.

Boelman Shaw Tax & Financial Planning is a full-service, independent financial consulting firm.  We do not receive commissions on products we sell.  Our customers are our priority.  We provide investment and tax planning, as well as tax preparation and IRS representation services.  Providing this range of services enables us to create a more comprehensive tax and investment strategy than professionals with a more limited focus.  Contact our Des Moines office to schedule a free financial consultation and learn about how we can help you create the future you desire.

Topics: Financial Planning

Written by Jason Shaw