Deferred and immediate annuities: Understanding the difference

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In search of retirement income security.

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Annuities are financial products sold by insurance companies that help retirees generate a guaranteed stream of lifetime income. Annuities come in two varieties: immediate and deferred. As the names suggest, you receive funds from an immediate annuity sooner than a deferred one.

Annuities can add a degree of certainty to retirement income. But they aren’t right for everyone. Annuities typically have high fees, and some have surrender costs that kick in if you decide the annuity isn’t right for you and you want your money back before a specified time has elapsed. Further, the fees and expenses associated with annuities can be confusing, and they aren’t always transparent.

Annuities are typically sold by insurance agents or registered representatives. Although many of these financial professionals are highly ethical and competent, they are not fiduciaries (who are required to consistently act in your best interest). Financial advisors who sell annuities may earn commissions (about 1% to 8% of the annuity contract price), so they may be caught in a conflict of interest—choosing between providing the best advice for you or recommending a product or service that will result in higher compensation for themselves.

An immediate annuity can begin payments to the annuity contract holder within a month of the contract purchase, and generally no later than within one year. The contract is typically purchased with a single payment, called a single premium immediate annuity (SPIA).

Before payments start, you must decide how often and for how long you want to receive funds from the annuity. Annuity contracts typically offer several options for converting the premium you paid into periodic payments, known as annuitization.

An immediate annuity might be purchased by a retiree or worker nearing retirement who wants to take a portion of their retirement nest egg and lock in a monthly benefit they cannot outlive.

Payments from a deferred annuity start at least a year or more after the purchase of the contract. Deferred annuities can be purchased with a single payment or a series of premium payments over time.

The premiums paid into the contract grow during the contract’s accumulation period. Once the annuity contract owner decides to take distributions from the account, they typically have several annuitization options, as well as other distribution options (such as one or more lump sums) based on the contract terms.

A deferred annuity is often purchased by someone who’s still working as part of their overall retirement planning strategy, or by someone who is nearing or early in their retirement years. In either case, a deferred annuity can serve as added insurance to help minimize the chances of outliving your retirement savings, since payments won’t be distributed to you until later on.

Both immediate and deferred annuities are available in fixed, variable, or indexed forms:

The annuity distribution options vary from contract to contract, but they typically involve annuitization into monthly payments or lump sums.

Typical annuitization options include:

Some contracts offer a death benefit and the ability for named beneficiaries to receive payments if the contract owner should die before the contract is annuitized (that is, before a payment stream begins) or during the annuitization period. Death benefits can vary widely from annuity to annuity, understanding how they work for a specific contract you may be considering is key.

Whether immediate or deferred, it’s important to understand how annuities are taxed.

If you contributed after-tax dollars to your annuity, the income payments you receive after annuitization are partially taxable:

To calculate the taxable portion, the Internal Revenue Service (IRS) uses a ratio of the cost of the annuity to the total expected return and splits the annuity payments into taxable and nontaxable portions, as discussed in IRS Publication 575.

Annuities held in an individual retirement account (IRA) or 401(k) plan are taxed based on the rules for that retirement account. Note that Roth IRA annuities are funded with after-tax dollars and grow tax-free, so withdrawals are not usually subject to income tax.

If you withdraw funds from your annuity before it’s annuitized (before income payments begin), taxes are calculated on a “last-in, first-out” basis, meaning that withdrawals are assumed to be earnings first. This portion is taxed as ordinary income.

Also, if you withdraw annuity funds before age 59 1/2, you’ll likely be subject to a 10% penalty in addition to applicable taxes on the taxable portion of the withdrawal.

Immediate and deferred annuities can be useful tools for retirement income planning. They have different characteristics, and both types come in several varieties, including fixed, variable, and indexed.

Before committing your money to an immediate, deferred, or other type of annuity, be sure to understand how the annuity works and the expenses, fees, and any surrender charges you might incur. Most importantly, be sure that the annuity benefits your overall retirement plan.