What Is a Deferred Annuity & How Does It Work?

A person who wants to set aside money today in exchange for income in the future sometimes considers a deferred annuity. These annuities let the holder delay the payout from their investment until years or even decades down the road. Deferred annuities can be attractive for those who want to supplement retirement income by contributing to an annuity while they’re still working.

What is a deferred annuity?

A deferred annuity, like all annuity investments, is a contract between an individual and an annuity seller—usually an insurance company. The investor funds the annuity through a series of premium payments or a lump sum. The company invests the money according to the contract’s terms and the money grows tax deferred. The annuity provider delivers the investor’s payout at a specified date in the future, either as regular periodic payments or a single sum. Investors who funded the annuity with after-tax dollars pay taxes only on the interest the annuity earned; investors who use pretax dollars are taxed on the total amount of the payout.

The “deferred” designation means the holder must wait at least a year before taking their disbursements. Many people delay collecting for several decades, allowing their funds to grow before they’re converted into payments, known as annuitization. The decision to annuitize is irrevocable; the holder won’t be able to access their funds outside of receiving the stipulated payments.

Deferred annuities are not required to turn the investor’s funds into a regular stream of income. Some deferred annuities are never annuitized and act as a form of life insurance or long-term savings. Investors can take out money as they need it until the account is empty, known as systematic withdrawals. They can withdraw all the money at once in a lump sum. They can transfer the assets to a different annuity or account. Some deferred annuity contracts offer riders that provide regular income without annuitization. The contract’s terms govern the options.

Deferred annuities differ from immediate annuities in the time that elapses before disbursements can begin. Immediate annuities, as the name suggests, start paying shortly after the individual deposits a lump sum.

Types of deferred annuities

Investors who want to save with a deferred annuity can choose from three main options. The selections vary in how and where the annuity company invests the buyer’s money and the terms and guarantees the annuity provides.

• Fixed

  : A deferred fixed annuity guarantees the investor a predetermined minimum interest rate over a specified time and protects the principal. The annuity company invests in fixed-income securities, such as bonds or money market funds, which offer stable returns. Like all annuities, the money grows tax deferred until the holder begins taking payouts.‍

• Variable

  : A deferred variable annuity invests the holder’s money in the financial markets, usually through stock, bond, money market mutual and other funds. The holder chooses the investment portfolio’s general categories and weightings. The portfolio’s performance determines the investor’s payout. Returns are not guaranteed; a variable annuity can lose money if the portfolio doesn’t perform well.‍

• Indexed

  : A deferred indexed annuity offers a hybrid approach between the fixed and variable models. Investor returns are based on the performance of a financial index, such as the Standard & Poor’s 500 Index. Investors are also guaranteed a minimum interest rate. Indexed annuities cap the rate of return an investor can receive, limiting the holder’s gains if the index performs well.  

Most annuities are considered insurance products and are therefore regulated by state insurance commission. Variable annuities are subject to state oversight, but they also are classified as securities, and thus are subject to Securities and Exchange Commission rules.

Lifetime vs term annuities

Deferred annuities differ based on how long the payouts to the investor lasts—a specific fixed period of time or the remainder of the holder’s life.

• Lifetime deferred annuities

  : These annuities are structured to deliver future payments for as long as the holder lives. When the investor dies, the payments stop—even if death occurs shortly after the payments begin.‍

• Term deferred annuities

  : These investments, also called fixed-period annuities, pay out over a specific period, such as 20 years. When the holder dies, the payments continue to a beneficiary if the contract offers that option. Payments stop after the specified term, even if the holder is alive.

Single premium vs flexible premium annuities

Investors in deferred annuities also must decide how they want to pay for their contract—via a single lump sum or a series of payments over time.

• Single premium deferred annuities

  : These annuities, known as SPDAs, require the investor to make a one-time payment when the contract is established. The investment grows according to the contract’s terms. SPDAs can be fixed, variable, or indexed. People with a lump sum to invest and who won’t need the money in the near term may choose an SPDA.‍

• Flexible premium deferred annuities

  : These annuities let the buyer make many payments over time. The individual can routinely pay a specific amount in what’s known as a scheduled premium deferred annuity. Or they can vary the amounts and timing to reflect their ability to pay. Flexible premium deferred annuities may appeal to people with limited funds to invest at a given time. The holder can skip contributions or invest larger amounts as their circumstances dictate. This type of annuity may restrict the total amount a holder can invest during the life of the contract, which will limit the eventual payout they receive.

Potential benefits and drawbacks of deferred annuities

Deferred annuities have certain plusses and minuses for savers.

Potential benefits of deferred annuities

• Tax deferral

  : As with all annuities, deferred annuity returns accumulate tax deferred. This allows investors to put away money for decades without worrying about tax consequences until they begin taking distributions. ‍

• Guarantees

  : Some deferred annuities offer investor guarantees such as a minimum interest rate on their return and the protection of their principal.‍

• Lifetime benefits

  : Deferred annuities can provide income for a person’s entire life if their contract permits.‍

• Death benefit

  : Deferred annuities often include a death benefit, much like a life insurance policy. If the holder dies while the annuity is in its accumulation phase, heirs may receive some or all of the account balance.‍

• Unlimited contributions

  : Unlike 401(k) and individual retirement account (IRA) plans, people can save as much as they want in a deferred annuity.‍

• Growth

  : A deferred annuity gives money time to compound, which can boost an investor’s payout. In general, the longer the annuity is deferred, the higher the payout can be.

Potential drawbacks of deferred annuities

• Lack of liquidity

  : Like most annuities, deferred annuities limit the holder’s ability to withdraw money outside of the contract’s terms. Individuals pay a 10% tax penalty if they take funds out before age 59 ½ and must pay a surrender charge to the annuity provider to cancel their contract.‍

• Tax rate

  : Annuity contracts grow on a tax deferred basis. But when the investor begins taking distributions, the Internal Revenue Service taxes the annuity's earnings at the investor’s ordinary income rate, rather than a lower capital gains rate.‍

• Expenses

  : Commissions are paid to the selling agent and are built into the contract price. Commissions can be as high as 10% of the contract’s value depending on the annuity type and terms. Fees for administration, account management, special features, riders, and other options add to the annuity’s cost over time.‍

• Complexity

  : Most annuity contracts can be long and complex, making it difficult for even experienced investors to understand all of the terms and conditions. Deferred annuities often have lots of bells and whistles. In general, the more complex the annuity the higher the fees.

The bottom line

Deferred annuities allow a person to save tax deferred and receive income at a future date. Individuals can contribute as much money as they choose and can receive their payout in various forms and time frames. Income can last a lifetime, reducing an investor’s fear of running out of money.

Deferred annuities do have drawbacks, and they can be complex. Annuities linked to financial markets carry risk. Money invested in an annuity can be almost impossible to withdraw early  without paying hefty fees. Commissions, fees, and expenses raise an annuity’s price tag.