Deferred Annuities

An annuity is a financial product purchased from an insurance company (“insurer”). It's designed to produce a monthly stream of income, the payment of which is guaranteed for the life of the recipient (the “annuitant,” usually the owner but sometimes a third party named by the owner). Using calculations that take a number of variables into account, including the amount of money paid for the annuity and the life expectancy of the annuitant, the insurer determines the amount of the monthly annuity payment. Thus, a person can purchase an annuity and immediately start receiving that income – an immediate annuity. A deferred annuity is simply an annuity that hasn't yet been so converted – one which has been purchased, but which is being permitted to accumulate cash for an indeterminate amount of time before being "annuitized."

Advantages of a Deferred Annuity

Some popular consumer advocates recommend immediate annuities, but also recommend keeping funds in other types of accounts, such as mutual funds or bank certificates of deposit (“CDs”) until they're ready to be annuitized. There are many advantages to purchasing a deferred annuity instead of accumulating cash in another type of investment, though, among them being preferential tax treatment, safety, convenience of withdrawing funds, avoidance of probate if the owner dies, and avoidance of the downside of investing in the stock market.

Preferential Tax Treatment

The income generated by an annuity is not considered income to the owner as long as it remains on deposit. By contrast, when interest is paid on bank CDs or mutual funds, tax is due on those amounts in the tax year they're paid and the amounts are reported to the IRS. This means that all other things being equal, the growth of an annuity will be significantly greater than the growth of accounts which are taxed annually.

Safety

Since annuities, like all insurance products, are guaranteed by all the insurance companies doing business in the state they're issued in, annuities are just as safe as bank-issued CDs, which are insured by the FDIC, and much safer than investments in the stock market.

Convenience of Withdrawing Funds

An annuity owner faced with a need for cash can withdraw the exact amount needed from the annuity, leaving the balance intact and earning interest. Most annuities permit the annual withdrawal of up to ten or fifteen percent without penalty, and then impose a “surrender charge” on the balance of the withdrawal, with the amount being determined by the age of the annuity (i.e., the older the annuity, the lower the surrender charge). The owner of a CD, by contrast, often must liquidate the entire CD, paying a penalty (usually forfeiting three to six months interest). This is especially vexing if the liquidation occurs when rates are low, so that not only does the owner sacrifice up to six months of a good interest rate, if the un-needed funds are invested in a new CD at prevailing (lower) rates, it represents an additional loss. In addition, for a CD owner who regularly permits the bank to roll CDs over to new CDs at prevailing rates, there's really a very short window of opportunity annually to withdraw funds completely without penalty, as opposed to annuities, which always offer some penalty-free withdrawals, and reduce their surrender charges over time, so that ultimately all withdrawals from an annuity are penalty-free.

Avoidance of Probate

A little-known feature of annuities is that they generally are passed directly to the beneficiary upon the death of the owner, without having to go through the probate process. They are not made public (as is the rest of the information about a decedent's estate) and they are not included in the value of the estate (a benefit for many reasons, including estate tax planning).

Avoidance of the Downside of Investing in the Stock Market

There are obviously many advantages to investing in the stock market, chief among them the opportunity for significant gains in a short period of time. The downside, of course, is the potential for significant loss in a short period of time. The advantages make the stock market an attractive opportunity for younger investors, just as the downsides make the market unattractive from the perspective of investors approaching retirement age.

Annuitization and Due Diligence

At any point in an annuity's life, it can be converted to a guaranteed monthly income stream without penalty. This decision should not be taken lightly, however, because upon annuitization, the owner loses all control over the annuity account, and his only right is to the monthly check for the rest of his life. Annuitization should only be done when the income is necessary, since it's an irrevocable decision. In addition, because the payments generally stop upon the death of the annuitant, arrangements should be made in the annuitization process to guarantee a set minimum number of payments, called a “period certain.” This period is usually five, ten or twenty years, although other options may be available depending on the insurer, and guarantees that the amount paid out will at least equal the value of the annuity account before annuitization.

Pros and Cons of the Deferred Annuity

The practice of taking premiums from customers to pay for future regular income payments began in the 19th century and were called an annuity. The individual who wanted to buy an annuity paid the premium in one lump sum and began to receive regular payments almost immediately from their annuity.

During the 20th century, insurance companies wanted to make annuities available to people who could not afford the lump sum payment. Thus, the regularly schedulled payments spread out over many years to buy an annuity began. The insurance company would collect the payments, invest the funds and not pay the contributor until his annuity matured. This type of annuity became known as the deferred annuity.

Here are some pros of the Deferred Annuity:

• The 10% tax penalty is not charged to heirs if you die before the annuity matures.
• The 10% tax penalty is not charged if you become disabled before your annuity matures.
• Minimum rate of return is guaranteed.
• Payments into the annuity is tax deferred.
• Principal is secure.
• You can choose a bailout provision or take out sums that are free of penalties.
• The amount of the contributions into the annuity does not change throughout the years, this allows you to plan accordingly and avoid surprises.
• You are assured of a stable income when the annuity matures regardless of the state of the financial markets.

Regardless of the type of investments you make there are always some pitfalls, here are some cons to consider before investing in annuities:

• 10% tax penalty if income is taken out before the annuitant is 59 years old.
• Penalties are imposed if withdrawals are greater than stated in the contract.
• High Surrender Charges
• Some annuity contracts may have several hidden fees and commissions.

There are some bright spots to the IRS threat. The IRS does not tax your principle. What is taxed is only the amount of money that you earned over your own contributions to your annuity. You make less money with the 10% IRS tax but you do not really lose your initial investment or have any of it taken back by tax. The good news is that the IRS 10% tax penalty can be circumvented. Simply don't take out any of your annuity money until you become 59. 5 years old.

Deferred Annuities Glossary

Simply put, a deferred annuity is typically used by people who are trying to save for retirement. These are individuals who want to investment their money into a plan that will earn interest for many years. Individuals who are also looking for a higher savings rate than what is usually offered in CDs.

Deferred Annuity- a contract that is issued by an insurance company. An individual pays into the annuity for a number of years. Deferred annuities do not become payable until after a certain period of time, which is determined by the investor. The feature that attracts potential investors to deferred annuities is that they receive special tax considerations. With a deferred annuity, income tax is deferred. That means that your money isn’t taxed as long as it stays in the annuity. Do no confuse this with tax free. You will eventually have to pay income tax on any monies accumulated in your annuity. Another positive feature of deferred annuities is that you can invest as much money as you would like. There is no IRS restriction on the amount of money that can be invested yearly into a deferred annuity like there is with Individual Retirement Accounts (IRAs).

CD-type Deferred Annuities- a combination of a fixed annuity and a CD. It guarantees that the investor will have a fixed interest rate for the entire duration of the contract. A CD-type deferred annuity contract can range from one to ten years. Typically you’ll see rates average between 3 and 10%.

Fixed Deferred Annuities- also called tax-deferred are contracts between the investor and insurance company that guarantees your income. Basically, the insurance company credits you interest on the money that you invest and you don’t pay taxes on the earnings until you make a withdrawal. This is the essential deferred annuity. A fixed deferred annuity is actually the safest way to invest your money if you are seriously looking for a deferred annuity. There are no financial risks involved at all and your money is guaranteed down to the last penny. Plus, you end up saving more money with fixed deferred annuities. By not paying taxes right away on your money, it compounds faster because you are earning interest on funds that would have gone to the IRS. However, like any retirement plan, there are fees and tax penalties for early withdrawal.

Equity Index Deferred annuities-These can be rather complicated. With an equity index annuity, your investment is linked to one of the stock market indexes. If you don’t mind taking risks with your investments, this type of deferred annuities can work. If you already have funds invested in CDs, IRA accounts, or in money market accounts, an equity index deferred annuity is a great way to protect it and increase your earnings potential. With your funds being linked to the stock market, it seems rather risky to place your money in one of these types of annuities. However, if the stock market goes down, you will not lose your money. Most equity index annuity contracts guarantee a minimum annual return.