If you’re nearing retirement and have already built substantial savings, a deferred annuity can help you supplement your retirement income by allowing it to grow with compound interest and tax deferral. When purchased with non-qualified funds, annuities aren’t subject to contribution limits or required mandatory distributions like IRAs and 401(k)s. As a result, a deferred annuity purchased with after-tax dollars allows you to save more than a qualified retirement account.
An annuity is a contract with an insurance company that guarantees a future stream of income in exchange for either a single lump-sum payment or a series of payments. A deferred annuity (in contrast to an immediate annuity) is designed to grow for a number of years before it begins paying this income stream. During this time, known as the accumulation period, the money used to fund the annuity grows at a guaranteed minimum rate, which varies depending on the insurer and the specific annuity product you choose.
After the accumulation phase, the distribution phase begins. This is when the annuity begins paying the annuitant their stream of income. Depending on the terms of the annuity contract, payments can last for the life of the annuitant, for a specified number of years, or both; whichever is longer.
The combination of compound interest and tax-deferred growth gives deferred annuities a distinct edge over savings vehicles like certificates of deposit (CDs), which are taxed annually on their growth.
Compound interest is interest that’s paid on the total amount in the account, not just the principal. For example, if you have $10,000 earning 2.5% simple interest, your account will gain $250 each year. If the account earns compound interest, on the other hand, it will earn $250 the first year, $256.25 the second year ($10,250 x 2.5%), and so on, gaining more earning power with time.
When taxes are taken from an account each year, less is left in it to grow. Additionally, today’s low interest rates have kept CD returns low, while annuities can often provide considerably better rates. With more money left in the account each year due to tax deferral and, in many cases, a higher interest rate, the compound interest that an annuity earns becomes even more robust.
While it is not possible to take a withdrawal from an immediate annuity, this is an option with deferred annuities. Be aware, however, that if you take a withdrawal before age 59 ½, the amount withdrawn will be subject to a 10% tax penalty unless you qualify for specific exceptions, such as permanent and total disability or exceptionally high medical expenses.
The specific rules and procedures for annuity withdrawals are spelled out in the annuity contract and can vary widely. Before taking a withdrawal, make sure you fully understand all associated costs, including penalties and fees. Often, withdrawal fees will decrease over time and may even disappear after the accumulation period has passed. Sometimes, insurers will reduce the interest rate paid on an annuity rather than charging a withdrawal fee outright. Annuities may also be subject to a market value adjustment in the event that a certain amount is withdrawn. This can have either a positive or a negative effect on an annuity’s interest rate, depending on the direction of interest rate movement over the relevant timeframe.
The guaranteed stream of income that an annuity provides can help ensure that you can meet essential expenses for the rest of your life. It can be an important supplement to Social Security and income from other retirement accounts.
Deferred annuities can also offer riders that provide for a waiver of surrender fees in case you die during the accumulation period. Because this risk is unavoidable, this waiver is an important feature for a deferred annuity.
ELCO Mutual proudly offers both single premium and flexible premium deferred annuities to help you secure your future. For more information about deferred annuities, download our free ebook!