A deferred annuity is a tax-efficient way to save money.
While you are saving money into deferred annuity, you pay no tax on interest or dividends earned. This is the same tax treatment as IRAs and 401(k)s.
Over a number of years, if you are fortunate, you may be able to save a significant amount of money.
The Deferred Annuity Process – Periodic Payments
In addition to periodic payments, single-premium deferred annuities are offered by insurance companies. Here you invest a lump sum hoping that over time it will grow into a larger amount.
The Deferred Annuity Process – Single Premium
Whether you invest in a periodic payment or a single premium deferred annuity or both, you will pay tax only when you finally withdraw your money. You pay tax only on your gains, not on the money you invested.
Deferral of tax means that you end up accumulating more money than if you paid tax on your gains each year.
Your gains are taxed at the time you withdraw money as if they were ordinary income. The deferred annuity can be particularly beneficial if you pay tax at a higher rate while you were saving and you withdraw money when you are paying tax at a lower rate.
How Does Tax Deferral Work to Accumulate More Money?
Tax deferral works because your interest is allowed to compound tax-free. If you are unsure about how this works, or how big the effect is, look at our tax deferral page.
Withdrawing Money From of a Deferred Annuity
While you are saving in a deferred annuity plan, you money remains available for you to withdraw at all times. You can withdraw limited amounts each year or close the account at any time.
If you should choose to close the account, your will incur costs:
- You may be charged surrender fees by the insurance company if you close the plan within a few years of starting it.
- You will pay taxes on any gains made while the account was open.
- You will pay 10% extra tax on your investment gains if you take a lump sum before you are aged 59.5 years.
Closing your deferred annuity account early? Careful of those sharks. They all want a bite.
Image by Ryan Espanto.
Who do Deferred Annuities Work Best For?
Examples of people who deferred annuities tend to work best for are:
- People whose tax rate is high now, but who expect it will be lower some time in the future. These people can avoid some tax if they save into a deferred annuity and then withdraw the money in instalments when their tax rate is lower – typically in retirement.
- People who have maxed out on their employers’ salary reduction plan but still want to save more for retirement.
- People who have unusually large incomes some years and lower incomes in other years can find deferred annuities useful, because unlike IRAs and employer sponsored plans, there are no federal limits on contributions to deferred annuities.
Be Careful Of
- Your precise current and expected future tax position. If you currently pay income tax at a high rate, and you expect to still pay income tax at a high rate when you receive income from your annuity, it could be more profitable to invest your money into mutual funds instead of a deferred variable annuity.
- Early surrender fees. You will be charged fees if you close your account within the first few years of opening it. Try not to.
- Sales commissions and other types of loading which can reduce the performance of your investment. Look at how much money will be taken from you – some commissions can be over 10%!
If commissions and loading are going to exceed the tax advantages of the deferred annuity, there is no point using it as a savings vehicle. Make sure you get a statement of all fees, commissions and loading before investing. Only invest if it is to your advantage to do so.