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. Investors often use deferred annuities to supplement their other retirement income, such as Social Security. Deferred annuities differ from immediate annuities, which begin making payments right away.

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. 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 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.

Special Considerations

Deferred annuities should be considered long-term investments because they are less liquid than, for example, mutual funds purchased outside of an annuity.

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.

Finally, deferred annuities often include a death benefit component. If the owner dies while the annuity is still in its accumulation phase, their heirs may receive some or all of the account's value. If the annuity has entered the payout 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.