Understanding Deferred Income Annuities

Written by Hersh Stern Updated Monday, February 2, 2015

understanding deferred income annuities

A Deferred Income Annuity (sometimes referred to as an "Longevity Annuity") may be the right annuity for you if you are looking for payments that begin at a future date (from two to thirty years hence) and continue for the rest of your life or for a specified period of time. The annuity is purchased from an insurance company with either a single lump sum amount called a premium, or with multiple deposits over time.

How does a deferred income annuity work? In return for your lump sum, the insurance company promises to make regular payments to you (or to a payee you specify) starting at a specified date for the chosen length of time – most commonly for the remainder of your life, however long that may be.

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When choosing a deferred income annuity, you can choose how frequently you receive payments – often referred to as the “mode.” While annuity buyers typically choose to receive payments monthly, you may choose quarterly or even yearly instead.

In today’s deferred income annuity marketplace, there are a number of ways the annuity can be customized to suit your specific life situation and concerns. In exchange for the guarantee of payments, you give up the right to demand the return of your original premium. Unlike some forms of life insurance or other types of annuities, you are generally unable to revise or cash in the deferred income annuity once the 10-day "free look" period has passed.

You can fund your deferred income annuity in a number of ways, including cash from a maturing Certificate of Deposit (CD), exchanging monies accumulated in a Deferred Annuity account, proceeds from the sale of stocks, bonds, a home or a business, a lump sum distribution from a tax-qualified defined benefit or 401k, or an IRA account.

Why should I consider buying an Deferred Income Annuity? What are its advantages to me?

A deferred income annuity comes with many important advantages. Here are just a few:

Security

The annuity provides stable lifetime income which can never be outlived or which may be guaranteed for a specified period. This advantage is crucially important to annuitants who may have previously feared outliving their savings.

Simplicity

An annuity is pretty much “get it and forget it.” Once it is set, the only work you are required to do is collect your regular payments. With a deferred income annuity, you do not need to watch markets or track interest rates and dividends.

Higher Returns

The interest rates used by insurance companies to calculate deferred income annuity income are generally higher than CD or Treasury rates. Since part of the principal is returned with each payment, greater amounts are received than would be provided by interest alone.

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Preferred Tax Treatment

A deferred income annuity may be a good strategy to defer taxes until later in your retirement when you may be taxed at a lower rate. This differs from other types of annuities for which the tax burden is “front loaded.”

Safety of Principal

Funds are guaranteed by assets of insurer and not subject to the fluctuations of financial markets.

No sales or administrative charges

Deferred income annuities do not have annual account management or maintenance charges. 100% of your premium goes towards your monthly income.

How can you customize a deferred income annuity?

You may hear a lifetime deferred income annuity called by a number of different names, including "Single Life," "Joint Life," "Life and Period Certain", or "Refund" annuity. Regardless of its name, by ensuring that you will never outlive your income, a life annuity is a powerful retirement planning tool. What’s more, a life only annuity generally offers the highest payout of any lifetime annuity, because it carries the smallest risk for the insurer.

When you shop for a deferred income annuity, you will find that one of the key factors in pricing is your age and life expectancy. In a sense, purchasing a deferred income annuity is like making a bet with an insurance company about how long you will live. Since the insurer will stop making payments when you die, it is betting that you won't live beyond your life expectancy. On the other hand, if you live longer than predicted, your return may be far greater than estimated.

Deferred income annuity coverage can be increased by including a second person ("Joint and Survivor" annuity), by adding a guaranteed period of time ("Period Certain" annuity), or by guaranteeing that payments will continue at least until the original purchase amount has been paid out ("Refund" annuity). This added risk to the insurer is likely to reduce monthly payments by about 5% to 15%, depending on the age of the annuitants and the length of the guarantee period.

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You may want to consider a deferred income annuity with special options if:

1. You wish to guarantee lifetime income for both yourself and a spouse ("Joint and Survivor" annuity)

2. You want payments to continue for a specified period (e.g. 5 or 10 years or more) to a designated beneficiary ("Certain and Continuous" annuity)

3. You want to ensure that should you die before your initial principal has been distributed, an amount equal to the balance of the deposit continues to a named beneficiary ("Refund" annuity).

What about funding my annuity? Can you explain the difference between qualified and non-qualified funds?

The way your annuity payments are taxed depends upon the source of the funds you use to purchase it.

Qualified Deferred Income Annuities

When applied to deferred income annuities, the term qualified refers to the tax status of the source of funds used for purchasing the annuity. These are premium dollars which until now have "qualified" for IRS exemption from income taxes. The whole payment received each month from a qualified annuity is taxable as income (since income taxes have not yet been paid on these funds). Qualified annuities may either come from corporate-sponsored retirement plans (such as Defined Benefit or Defined Contribution Plans), Lump Sum distributions from such retirement plans, or from such individual retirement arrangements as IRAs, SEPs, and Section 403(b) tax-sheltered annuities, or Section 1035 annuity or life insurance exchanges.

Non-qualified Deferred Income Annuities

Non-qualified deferred income annuities are purchased with monies which have not enjoyed any tax-sheltered status and for which taxes have already been paid. A part of each monthly payment is considered a return of previously taxed principal and therefore excluded from taxation. The amount excluded from taxes is calculated by an Exclusion Ratio, which appears on most annuity quotation sheets. Non-qualified annuities may be purchased by employers for situations such as deferred compensation or supplemental income programs, or by individuals investing their after-tax savings accounts or money market accounts, CD's, proceeds from the sale of a house, business, mutual funds, other investments, or from an inheritance or proceeds from a life insurance settlement.

Comments (2)

  1. Michael:
    Feb 02, 2015 at 01:54 PM

    Just what kind of annuity is this? Is this a variable annuity?

  2. Hersh Stern:
    Feb 02, 2015 at 02:16 PM

    Hi Michael,

    These annuities are not variable annuities. They are “Deferred Income” annuities. The amounts in a deferred income annuity are fixed and guaranteed.

    There is no “variability” or indexing of the monthly income amounts the insurance companies will pay you. Variable annuities are annuities where your premium is invested in mutual-fund-like or bond-like sub-accounts and where the amount of the monthly payments you receive may go up or down.

    -Hersh

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