Immediate vs. Deferred Annuity Payout Options Compared
Immediate annuities and deferred annuities are two sub-types of annuities you may be considering as part of your retirement plan.
Each type of annuities may have several other subtypes. One key feature differentiates these two major classes.
Immediate annuities begin making payments to you immediately.
Deferred annuities start making payments to you in the future.
Here’s how each type of annuity generally works. This information can help you figure out immediate vs. deferred annuity payout options.
How Immediate Annuities Work
Immediate annuities are a type of insurance product. You usually enter into these contracts with an insurance company, such as a life insurance company.
These annuities typically require you to make a lump sum payment upfront.
In exchange for this payment, the insurance company will give you a stream of payments starting immediately.
Depending on the type of immediate annuity you choose, the annuity payout options may be fixed or variable.
A fixed annuity tends to offer fixed payments. This is because the rate of return on money within the annuity doesn’t change.
As you’d expect, variable annuities have payments that may change.
This is because the rate of return you earn on your money could change over a period of time based on the rules in the contract.
Additionally, the annuity may make income payments for the rest of your life. This is called a life annuity. Other annuities may only pay for a set period of time.
Immediate annuities can be beneficial in several ways.
Start receiving payments immediately
Someone about to retire may be concerned about not having a paycheck. An immediate annuity can start making payments immediately.
In a sense, this could help you continue receiving a paycheck in retirement. Even so, it isn’t exactly the same.
Could have guaranteed income in retirement
If you carefully choose your annuity, you may secure a fixed payment for life to fund your retirement.
That payment can continue paying a surviving spouse if you pick a joint and survivor annuity.
Using money in a tax-deferred retirement account to buy a tax-deferred annuity can help you continue getting tax-deferred treatment on your retirement money.
You have to pay taxes when you withdraw the money from the annuity.
Immediate annuities aren’t perfect. Here are some of the downsides.
You don’t give your money time to grow
Immediate annuities start paying out immediately. When payments start flowing out, that means that money didn’t have time to grow.
Thankfully, deferred annuities can help avoid this issue.
Payments could decrease in value
Annuity payments may continue for life, but their value may not be the same.
Fixed annuities do offer a set rate of return and fixed payments. This alleviates part of the problem.
Unfortunately, inflation may cause the annuity payments to decrease in value.
If the annuity’s fixed rate of return is 3% and inflation shoots up to 5%, your money loses 2% of its buying power each year.
Annuities are full of fees. Some annuities are worse than others.
Most annuities require you to pay an annual mortality fee. This helps cover the risks the insurer takes on by issuing your annuity contract.
Other fees could include administrative fees and fees for investment management depending on the investments you choose in certain annuities.
If you want to remove money from the annuity early, you may even have to pay a surrender fee.
Who Immediate Annuities May Make Sense For
People who have identified they’ll be purchasing some sort of annuity will generally find an immediate annuity to be a good fit if they’re about to retire.
They can use their nest egg to buy an annuity contract.
The contract will make regular payments to either create or supplement a retirement income.
Non-annuity investments may better serve people about to retire.
Make sure to consider all options before purchasing an immediate annuity.
How Deferred Annuities Work
Deferred annuities require you to make a single lump sum or a series of payments. Then, the annuity company starts making payments to you at some point in the future.
The accumulation phase is when you initially make a payment or continue making payments. It lasts until you start receiving payments from the annuity.
During this phase, the money grows based on the terms of your contract.
Once you start receiving payments, you’ve entered the annuitization phase of the contract.
Your investments within the annuity may continue growing if your contract allows this.
Deferred annuities come in several varieties. The deferred annuity type you choose will depend on the benefits and options you want.
Deferred annuities can offer several benefits.
Let your money grow
Deferred annuities give your money time to grow. The growth options will be defined in the contract.
As long as your money grows faster than inflation, it may benefit your future retirement.
Gains within an annuity grow tax-deferred. You don’t have to pay taxes on them as you earn them.
Instead, you pay ordinary income taxes on earnings when you withdraw them.
Depending on the type of annuity, the taxation could be a bit complicated.
Helps retirement planning
A deferred annuity could help give some stability to a future retirement plan.
The stream of payments an annuity gives you can ease many people’s minds in the years leading up to retirement.
If you value certainty, some annuity types provide more stable growth. You do often give up potentially more significant returns for that certainty.
You can also work on building other assets outside of the annuity to support your retirement.
Deferred annuities may seem like a good idea. They do have drawbacks, though.
Fees Impact Returns Over Decades
Annuities are full of fees.
- mortality fees
- administration fees
- surrender charges
- and more...
When you invest in an annuity over decades, those fees represent a surprisingly large dollar amount due to compounding.
Compare your annuity options to other investments on an after-fee basis.
You may be surprised how much more your investments could earn with a low-fee index fund. Index funds usually come with additional risks, though.
Inflation could eat away at value
A fixed annuity may provide a 4% annual return. This initially seems decent.
You must also consider inflation. If inflation consistently runs 2%, your real buying power only increases by 2%.
If that 2% growth doesn’t provide enough returns to retire at your target retirement age, you have to make changes.
You’ll either have to invest more money or delay retirement.
Who Deferred Annuities Make Sense For
Deferred annuities make the most sense for people earlier in life. They may want to contribute to an annuity over decades. This can help grow a large balance.
While they’re far from perfect, people who want a stream of retirement income from an annuity may prefer a deferred annuity.
This could help alleviate part of the risk of building a nest egg themselves.
Deferred annuities come with several costs.
People these products may be a good fit for must be willing to pay those costs. The benefit is the convenience they receive.
Taxation of Annuities in General
In general, annuities are tax-deferred financial products.
Some people buy them within a tax-advantaged account, such as an IRA, 401(k), or 403(b).
In this case, the money used to purchase the annuity was contributed to the account on a pre-tax basis.
All withdrawals from these qualified annuities require you to pay ordinary income taxes. These withdrawals do not qualify for capital gains tax rates.
If you fund an annuity outside of a retirement account, you won’t get the same tax benefit for contributions. Earnings still typically grow tax-deferred, though.
When you withdraw money from the annuity, your initial contributions shouldn’t normally be taxed.
Any earnings withdrawn will be taxed at your ordinary tax rate. This is higher than the capital gains tax rates.
The calculations to determine the taxable and non-taxable parts of annuity withdrawals can be complex. Tax laws also change over time.
Consult a tax professional before you sign an annuity contract. They can help you determine how your specific contract could be taxed.
Consult a Fee-Only Fiduciary Financial Advisor
Annuity salespeople aren’t obligated to sell you the product that’s the best fit for your situation.
This can lead to a situation where they sell you a contract that isn’t as good for you but pays them a higher commission.
Annuities are also highly complex. They have several variables that can be changed or even negotiated.
To help make sure you’re getting the best deal possible, you may want to consult a fiduciary fee-only financial advisor.
A fiduciary is required to give you advice that fits your best interests. They have to go beyond making sure something is suitable for you.
Fee-only financial advisors earn money through the fees you pay them directly. This helps you know you’re getting the best advice because they don’t get a commission.
A fiduciary fee-only financial advisor can help you review the annuity contract offers you have received.
They may be able to help you negotiate a better offer or educate you about the common pitfalls of annuities.
Paying a fiduciary financial advisor may seem expensive. Their fee could save you a lot of money if you’re dealing with an unscrupulous salesperson.
Even if you get a fantastic contract, the fee can give you peace of mind.