Immediate & Deferred Annuities: Pros & Cons

By on January 14, 2016

Today’s economy and stock market are unpredictable. Social Security and strong economic growth are no longer guarantees. Pensions are becoming a thing of the past. People are living longer than ever. These are just a few reasons retirement planning is so important for Baby Boomers and Generations X, Y, and Z alike. There are a many retirement savings products out there that can help you build a nest egg so you are taken care of during your retirement years. Annuities are low-risk options to consider as part of your retirement strategy.

What is an Annuity?

An annuity is an insurance savings product available through insurance and finance companies. Annuities are attractive because they are relatively low-risk investments. You are guaranteed at least your initial investment. Also, taxes are deferred and they are not subjected to contribution limits, so you are able to invest as much money as you want into an annuity.  Unlike other retirement products that require you to wait until a certain age before you can take a distribution, you can start to receive income from your annuity whenever you want. However, you may have to pay the IRS a 10% tax for taking a distribution before age 59 ½.

When you invest in an annuity, you have the option to receive your income in a series of payments on a monthly, quarterly, or annual basis, or in a lump sum on a date of your choosing. The amount of income you receive depends on whether you have chosen a fixed-rate annuity, variable-rate annuity, or a combination of the two called an equity-indexed annuity. Fixed-rate annuities offer a guaranteed rate of return. Rates can fluctuate, but you are guaranteed at least your initial investment.

The payout amount from a variable-rate annuity depends on the performance of the annuity’s underlying investments. With equity-indexed annuities, you will receive a guaranteed minimum return with the potential for greater earnings based on fund performance. These various types of annuities all have their pros and cons.  Be sure to do your research and talk with your financial planner before deciding to include an annuity as part of your retirement portfolio.

Immediate vs. Deferred Annuities

There are two basic types of annuities: immediate and deferred. Which option you choose may depend on your age or current circumstances.

Immediate annuities are purchased with a lump sum premium. Typically, you begin to receive income soon after your initial investment or you can defer payments up to one year. In this case, any funds remaining in the annuity accumulate on a tax-deferred basis. When you receive your payment, you only pay taxes on interest income. Usually if you opt for an immediate annuity, you do not defer your payments and your income is determined by a formula based on if you elect payments for life, for a fixed period, or for a fixed amount. Immediate annuities are typically recommended for individuals near retirement age.

If you choose a deferred annuity, you will begin to receive payments on some date in the future that you specify. The money you contribute initially, and any contributions thereafter, earns interest for the set term. Taxes are deferred until you begin to receive your income. Deferred annuities are recommended for people who are planning for retirement and are not yet in need of their investments. Though, you can buy a deferred annuity at any time, even after retirement.

Immediate Annuities Pros & Cons

Pros

Immediate annuities have their advantages. The following points are why they are attractive to investors. These are also the common pitches used by sales reps to sell you on this particular type of investment.

  • Security – You have guaranteed income for life, for a fixed period, or a fixed amount. Annuities reduce “longevity risk”—the risk of outliving your money.
  • Simplicity – Payments are fixed.  And, you do not have worry about managing the investments. A financial planner does that for you.
  • Higher Returns – The returns on your investment are typically higher than other savings products like CDs or Treasury Bonds.
  • Tax Benefits – You only pay taxes on interest income. The majority of your payments are return of the principal.

Cons

While the advantages sound pretty good, there are some inconveniences to consider before deciding on an annuity.

  • No Liquidity – You are trading access to your money for a steady income stream.
  • No Contract Adjustment – When you purchase an annuity, you are locked into the contract and current interest rates.
  • No Inflation Adjustment – Fixed payments are not adjusted for inflation.
  • No Growth – Annuities do not have the potential for growth like stock funds.
  • Financial Success Dependent on Insurer – When you invest in an annuity, you invest in the company that issues it. Guaranteed income is dependent on the financial stability of the issuing company.

Tip! If you are interested in an immediate annuity, consider investing only a portion of your portfolio to cover fixed costs during retirement.

Deferred Annuities Pros & Cons

Pros

Deferred annuities share many of the same advantages as immediate annuities; they are just in the accumulation phase for a longer period of time. The security and tax benefits may be attractive, but you should be aware of the downsides to deferred annuities as well.

Cons

  • Capital Gains – The capital gains from stocks, bonds, and other tax-deferred savings products that you hold for more than one year are  taxed at a lower rate than ordinary income. The interest earned on deferred annuities is taxed as ordinary income. This may result in large tax bills for investors in higher tax brackets.
  • Bad Advice – Some insurers or financial planners may try to sway you toward a variable annuity for an account like a 401k or an IRA. Buyer beware! Such accounts already have tax benefits and a move like this does not make sense.
  • High Fees – There are many fees associated with purchasing an annuity—commissions, surrender charges for early distribution, administrative fees, mortality and expense charges, and underlying fund expenses and annual fees. Annuities have the potential to cost 2% to 3% per year, which can be a sizable chunk of your investment compared to mutual funds or index funds that cost much less.

Something else to keep in mind—insurers make money on annuity fees and management services. They invest your premiums and get to keep anything over and above what you are promised. If you pass away, they are entitled to funds remaining in your contract after fulfilling obligations to your beneficiaries.

Is an Annuity Right for You?

The concept of an annuity is relatively simple, but the products are pretty complex and there are a lot of details to understand. This list of questions can help you draw out pertinent information when broaching the subject of annuities with your financial planner:

  • What type of annuity best fits my retirement portfolio?
  • Do I have enough liquid cash to tie my money up in an annuity?
  • What is my financial obligation during the first year and subsequent years?
  • What is your commission, salesperson, for the first year and subsequent years?
  • What are the total costs of maintaining the annuity per year?
  • How do annuities compare to other tax-deferred retirement products like 401ks and IRAs?
  • How financially stable is the issuing company?

While there appears to be some drawbakcs, annuities serve a purpose in providing a low-risk investment option. Also, tax-free growth products may make sense for individuals in higher income tax brackets. Before deciding on an annuity, compare the pros and cons—particularly fee structures and earning potential—to that of other tax-advantaged retirement savings products such as 401ks and IRAs. You can then make an informed decision on whether to include an annuity in your retirement portfolio.

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About Scott Ho

FSN insurance and retirement journalist - Planning for your retirement or understanding your insurance needs can be confusing and difficulty. Scott knows these tasks can seem daunting. He offers his experience to make choosing insurance coverage and planning for your golden years a successful endeavor. Connect with Scott at !

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