The 100 Most Popular Financial Terms Explained by Thomas M. Herold - HTML preview

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What is a Deferred Annuity?

 

A Deferred Annuity refers to a specific kind of annuity contract. These types of annuities delay income payments (in the form of either a lump sum or installments) to the point where the investor chooses to obtain them. There are two principal stages in these kinds of annuities. These are the savings phase and the income phase. In the savings phase, individuals put money into the contract. The income phase is the one after the annuity becomes converted so that the payments are distributed as arranged. With deferred annuities there are several sub-types. These include fixed, variable, equity-indexed, and longevity.

 

A Fixed Deferred Annuity operates similarly to a CD Certificate of Deposit. The main difference lies in how the interest income must be claimed. With these annuities, it becomes longterm deferred until the owners take disbursements from the contract. These fixed contracts come with a guaranteed rate of interest that all funds earn. The insurance company stands behind the guarantee. These are attractive choices for those investors who are averse to risk and who do not require any interest income until after they turn 59 and ½ or older.

 

A variable Deferred Annuity is something like an assortment of mutual funds. With annuities, they refer to these as sub-accounts. Each owner has personal control over the investment risk he or she engages in through selecting particular sub-accounts which may cover both stocks and bonds. The returns on these investments will influence how well the annuity performs. For most investors, it benefits them more to purchase shares in several index mutual funds. This is because deferring taxes to retirement could mean that the owners will possibly pay higher taxes when they are retired than when they are working. The fees can also be as high as greater than three percent each year with many variable annuities.

 

Equity indexed annuities work much like the fixed annuities but also have variable annuitylike features. They possess two features. The first proves to be a guaranteed minimum return. The second is the ability to obtain a higher return than this by gaining from a formula which is based on one of the popular indices of the stock market like the S&P 500 or the Dow Jones Industrial Average. The downside to this type is that it typically comes with expensive surrender charges that can last over a ten to fifteen consecutive year long period.

 

Buying one of these last categories, the longevity annuity, is akin to obtaining insurance for a long life expectancy. It is helpful to consider a real life example to better understand how this works out in practice. An investor who is 60 might decide to pay in $150,000 to one of these longevity annuities. In exchange for this consideration, the insurance company which backs it will promise to pay out a set dollar amount of income for the rest of the holder’s life beginning 25 years later at age 85. The advantage to this type of arrangement is that the retirees can then spend their other retirement assets because they feel comfortable that there will be a steady income stream that will support them guaranteed the rest of their lives. All income and taxes would be deferred to the distribution age when the money begins being disbursed.

 

It is important to realize with these annuities that any early withdrawals realized before the owners reach their legal retirement age will come with a full 10 percent penalty tax on top of the regular income taxes which the IRS will assess. The income tax rate would be based on the tax bracket of the individual when they receive the distribution.

 

These deferred annuities have many interesting (but often expensive) options and features which the buyers can obtain. Some of these include future income guarantees and death benefits.