Immediate annuities offer immediate guaranteed income. Deferred annuities offer guaranteed income at some point in the future. While the investment options, fees, and tax advantages between immediate and deferred annuities are different, the primary difference concerns distribution method. It's also true that immediate and deferred annuities are often not suitable for the same person. Immediate annuities are ideal for those who are retired or about to retire. Deferred annuities are ideal for younger investors or for those who have maxed out their pre-tax retirement plans.
Funding Immediate Annuities
Immediate annuities are funded with a single premium. It can be money from a savings account, inheritance, or after-tax profits from the sale of property. Another current strategy is to fund an immediate annuity with distributions from a qualified retirement account. If you're over 70 ½ and are taking mandatory IRA or 401(k) distributions, you may want to consider an immediate annuity. Growth and earnings are tax-deferred and you can establish a permanent and guaranteed stream of income. With an immediate annuity, your payouts will begin within 12 months of the signing of the contract.
Funding Deferred Annuities
Deferred annuities have two separate and distinct stages. The first is the accumulation stage. During accumulation, which can last several years or decades, you make regular contributions into the annuity based on the terms of the contract. These contributions are known as the premiums. In most cases, you'll have a number of investment options from which to choose. A deferred variable annuity will pay a higher rate of return as long as the underlying investments increase. An indexed annuity is based on a stock market index, usually the S&P 500. It will invest in a mix of stocks and bonds, and will usually provide a measure of safety that doesn't come with a variable annuity.
Funds contributed to a deferred annuity grow tax-deferred. The deposits can be made with pre or post-tax dollars, making annuities a great retirement savings vehicle. Pre-tax dollars are added to a tax-qualified account, such as 401(k) or SEP IRA. Post-tax dollars are dollars that have been taxed in the year they were earned. For example, Roth IRAs are funded with post-tax dollars. If you purchase a deferred annuity with post-tax dollars, the annuity will grow tax-deferred at a faster rate than any other account that is funded with taxable earnings. If you have extra cash or need to begin saving more for retirement, consider a deferred annuity.
Immediate and Deferred Annuity Distributions
Once you annuitize an annuity and the payouts begin, you'll be responsible for paying taxes. Regardless of whether the annuity is immediate or deferred, the tax rates will be the same. Annuity distributions are taxed at ordinary income rates. And while the only amount that is subject to tax is the amount that's been earned, ordinary income tax rates for most people are higher than long-term capital gains taxes. If you're ready to begin taking distributions from an annuity, make sure you calculate the amount of tax that will be due once it's combined with your other income. You don't want to end up in a situation where the income from an annuity pushes you into a higher tax bracket.
The deferred earnings of an annuity are also subject to age limits. Currently, you cannot begin taking distributions from a deferred annuity without penalty until the age of 59 ½. A 10% penalty will normally be assessed if distributions are taken earlier.
Immediate and Deferred Annuity Risks
Immediate annuities are typically fixed annuities that pay a set return. The main risk with an immediate annuity is that the amount of income that's generated in a low interest rate environment will not be enough to cover expenses, which increase each year due to inflation. While the annuity might pay a rate that changes from year to year, it might be lower than the rate of inflation. This is the trade-off that occurs with an immediate annuity. In exchange for guaranteed income, you might have to settle for less income.
A COLA (cost of living adjustment) rider provides a solution for those investors who want to ensure that inflation does not eat into future purchasing power. A COLA rider will of course increase the price of the annuity, decreasing overall payouts, but it will at least pay an increased amount each year based on the consumer price index.
The primary risk of variable or indexed deferred annuities is loss of principal. Like all other investments, annuities can lose money. Whether it's an indexed or variable annuity, choosing a product that fits your level of risk tolerance and fits into a balanced portfolio is always the key.
Another risk associated with both types of annuities is the premature death of the annuity owner. If you die before you have received the amount you've paid in premiums or before distributions begin, the insurance company may keep the balance. For some retirees this is an acceptable cost for guaranteed lifetime income but for others it is not. Now, however, most insurance companies offer annuity products that guarantee the premium after death, minus charges and fees.
For example, if you purchase an annuity for $250,000 and die after having received only $150,000, your beneficiary will receive the balance of $100,000. In the case of a deferred annuity, if you die before distributions begin, your beneficiary will receive the full amount of the premiums but not the earnings. While it is certainly up to each individual investor to decide whether this type of "insurance" is needed on an annuity, it's often recommended that as much of the premium as possible is protected from loss.
Which Type of Annuity is Right for You?
Again, remember that an annuity is a contract. Money is not returned except in the form of distributions. If you're retired and need a guaranteed stream of lifetime income, consider an immediate annuity. But, be sure to keep enough cash on hand to cover emergencies. Annuity income can supplement dividend and bond income. Annuity income that is guaranteed has an advantage over dividend and bond income that is not.
If you're a younger investor in your 40s or 50s, consider a deferred annuity to grow your retirement income. By deferring taxes and income until a later date, you'll have significantly more assets at retirement. Be sure, however, to select a product that suits both your level of risk tolerance and your need for asset allocation and diversification.
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More Annuity Guidance
- Annuity Investment Guide — The complete guide to annuity investing.
- Fixed Annuities — Learn about the ins and outs of fixed annuities.
- Indexed Annuities — Learn about the ins and outs of indexed annuities.
- Variable Annuities — Learn about the ins and outs of variable annuities.
- Annuity FAQ — Answers to commonly asked annuity investment questions.