What is a Deferred Annuity?

A deferred annuity is a type of annuity that delays monthly or lump-sum payments until an investor-specified date. The interest usually grows tax-deferred before it is withdrawn.

How Does a Deferred Annuity Work?

There are two phases in the life of a deferred annuity: the savings or accumulation phase, and the income or annuitization phase. During the accumulation phase, the investor will deposit money into the account either periodically or all in one lump-sum. When the annuity reaches the contractually agreed-upon date, the investor will begin receiving several payments over a period of time or in one lump-sum.

It is important to note that earnings on a deferred annuity are only taxed when they're withdrawn. However, if an investor withdraws money before the contractually agreed-upon date, he or she may have to pay considerable surrender fees. Annuity owners younger than 59.5 years old may also have to pay a 10% penalty tax, even if the surrender period has expired.

Another important feature of deferred annuities is the family protection, or death benefit, which guarantees that, should the owner die during the accumulation phase, the beneficiary will receive at least the amount of the owner's investments minus withdrawals, or the current market value of the account.

Often, the beneficiary cannot take advantage of a 'step-up' in basis on an annuity, meaning that he or she becomes responsible for paying income taxes on all the gains in the account since it was opened.

Why Does a Deferred Annuity Matter?

Investors purchase deferred annuities for many reasons, the most common being the tax deferral of earnings, the lack of restrictions on the amount of the annual investment (unlike an IRA or 401(k)), and the guarantee of a lifelong annual income. Control over the investment decisions and the ability to switch between investments is also attractive to some investors.

Despite these advantages, wise investors must consider some important drawbacks to annuities. For one, annuity investors pay taxes on gains at their ordinary income tax rate (rather than the lower long-term capital gains tax rate) when they make withdrawals.

Fees are also major source of controversy for annuities. There are often front-end loads, state taxes, annual fees based on a percentage of the account value, early withdrawal penalties, etc., and they may offset much or all of an annuity's tax advantages. Variable annuities are particularly controversial because fees charged by their underlying mutual funds also burden them.

This is why less-than-stellar returns can turn into serious setbacks for some annuity investors. And even though investors can trade within their annuities and defer the taxes on the realized gains, most investors do not trade frequently enough to make this a huge advantage.

Pressuring sales tactics and less-than-transparent disclosure have also tarnished the image of annuities, so wise investors should be sure to read these disclosure materials and ask his or her financial consultant plenty of questions.

Ultimately, the appropriateness of an annuity is dependent on the investor's financial goals, tax situation, and the types of annuities available. Inflation and interest rate expectations may affect the type of annuity an investor chooses, as will the investor's wishes for his or her dependents and heirs.