Table of Contents

Deferred Annuity: Definition, Types, How They Work

By

Julia Kagan

Updated July 05, 2024

Reviewed by

David Kindness

Fact checked by

Yarilet Perez

Part of the Series

Annuity Definition and Guide

Annuities Overview

Types of Annuities: Part 1

Types of Annuities: Part 2

Calculating Present and Future Value

Tax Implications

Payouts, Distributions, and Withdrawals

Benefits and Risks

What Is a Deferred Annuity?

A deferred annuity is a contract with an insurance company that promises to pay the owner a regular income, or a lump sum, at some future date. Deferred annuities differ from immediate annuities, which begin making payments right away.

Key Takeaways

A deferred annuity is an insurance contract that promises to pay the buyer a regular income or a lump sum of money at some date in the future. Immediate annuities, by contrast, start paying right away.
Deferred annuities come in several different types—fixed, indexed, and variable—which determine how their rates of return are computed.
Withdrawals from a deferred annuity may be subject to surrender charges as well as a 10% tax penalty if the owner is under age 59½.

How Deferred Annuities Work

There are three basic types of deferred annuities: fixed, indexed, and variable. As their name implies, fixed annuities promise a specific, guaranteed rate of return on the money in the account. Indexed annuities provide a return that is based on the performance of a particular market index, such as the S&P 500. The return on variable annuities is based on the performance of a portfolio of mutual funds, or sub-accounts, chosen by the annuity owner.

All three types of deferred annuities grow on a tax-deferred basis.

The period when the investor is paying into the annuity is known as the accumulation phase (or savings phase). Once the investor elects to start receiving income, the payout phase (or income phase) begins. Many deferred annuities are structured to provide income for the rest of the owner's life and sometimes for their spouse's life as well.

Before purchasing an annuity, buyers should make sure they have enough money in a liquid emergency fund.

What Are the Disadvantages of a Deferred Annuity?

Prospective buyers should also be aware that annuities often have high fees compared to other types of retirement investments, including surrender charges. They are also complex and sometimes difficult to understand.

Most annuity contracts put strict limits on withdrawals, such as allowing just one per year. Withdrawals may also be subject to surrender fees charged by the insurer. In addition, if the account holder is under age 59½, they will generally face a 10% tax penalty on the amount of the withdrawal. That's on top of the income tax they have to pay on the withdrawal.

Is an Annuity Considered a Liquid Asset?

Deferred annuities should be considered long-term investments.

Annuities' liquidity varies based on the surrender charges laid out in the insurance contract. The surrender period is when you would need to pay a hefty fee to exit the contract—certainly something you'd want to avoid. The surrender charge—for example, 10%—declines over time until it arrives at zero. These surrender periods can last several years, even 15 years. During this time, most people would consider their investment to be illiquid.

However, once the surrender period has passed, the annuity becomes more liquid, relatively speaking. They may be considered to be more liquid than an asset that you must find a buyer for, such as a car or a home. But they are still less liquid than, for example, mutual funds purchased outside of an annuity.

What Happens to an Annuity After Death?

Deferred annuities often include a death benefit component. If the owner dies while the annuity is still in its accumulation (savings) phase, their heirs may receive some or all of the account's value. If the annuity has entered the payout (income) phase, however, the insurer may simply keep the remaining money unless the contract includes a provision to keep paying benefits to the owner's heirs for a certain number of years.

Do You Pay Taxes on a Deferred Annuity?

Owners of these insurance contracts pay taxes only when they make withdrawals, take a lump sum, or begin receiving income from the account. At that point, the money they receive is taxed at their ordinary income tax rate.

The Bottom Line

Investors often use deferred annuities to supplement their other retirement income, such as Social Security. They are part of a mix of assets that can sustain you in retirement. However, due to their high fees and relative illiquidity, they aren't the right choice in every scenario.

Article Sources

Investopedia requires writers to use primary sources to support their work. These include white papers, government data, original reporting, and interviews with industry experts. We also reference original research from other reputable publishers where appropriate. You can learn more about the standards we follow in producing accurate, unbiased content in our editorial policy.

Internal Revenue Service. "Topic No. 558 Additional Tax on Early Distributions From Retirement Plans Other Than IRAs."
Financial Industry Regulatory Authority (FINRA). "Annuities."
Investor.gov. "Surrender Charge."

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