How Do Deferred Annuities Work?
Annuities originally were funded by one lump sum deposit and they began paying monthly installments within one year from the date of that deposit. Today, however, they can be funded over a period of time with smaller deposit amounts and monthly distributions can be deferred for many years. This article provides general information to answer the question, "How do deferred annuities work?"
The phase in which money is being deposited into a deferred annuity is called the deferred phase or the accumulation phase. During this period, the funds deposited and the accumulated interest earned is both tax deferred, meaning taxes are not paid on the money until it is distributed from the account. Annuities are commonly used as retirement vehicles and since most people are in a lower tax bracket during retirement, deferring taxes generally results in severely decreased tax obligations. Distributions typically start when the account holder reaches a minimum of 59 ½ years of age, but most contracts also allow for up to 10% of the balance to be withdrawn annually without penalty. Early withdrawals in excess of the contracted amount will result in a 10% tax penalty imposed by the Internal Revenue Service and an additional 1-10% surrender charge imposed by the insurance company that sponsors the account.
Once the account has reached its contracted maturity, the next phase begins. This is known as the distribution or income phase, as the monthly withdrawals, or distributions, often replace a retirees former income source or paycheck. Several options exist for the timeframe of the distributions. Some people choose annuities that only last for a set number of years. Others choose lifetime annuities. These accounts were developed to provide income for a person's life, even if the person outlives the account balance. The original design called for any outstanding balances to be abandoned if the person died before the funds were distributed, allowing the funds to revert to the insurance company. Today, most accounts have provisions to leave any undistributed funds to the account holder's beneficiary of choice.
Interest is earned on deferred annuities in several different methods, depending on the account. Fixed interest rates generally lock in that rate for a specified time period such as one year. Because the rate becomes variable after the guaranteed timeframe expires, most contracts offer a bailout clause that allows the account holder to move the funds from the annuity without penalty. Variable rate accounts are riskier, but with great risks come great rewards. If the rates drop, the annuity can lose a considerable amount of money. Adversely, if the rates soar, the annuity can earn a substantially higher return than a fixed account could ever produce. Index deferred annuities offer a more conservative choice that offers higher interest rates than fixed accounts. The interest rates on these accounts are tied to an equity index like the Standard & Poor's 500, which provides more security than variable accounts. To determine the most appropriate and beneficial deferred annuity, an individual should always properly research the available products and rates on the market.