Immediate and Deferred Annuities: Making Both Work for a Secure Retirement

Joel Mathews |

Annuities has a long and historic lineage dating back to ancient times when Roman citizens and soldiers would receive an “annua”, or annual stipend,  from the government in exchange for a lump sum of money. Since then, the family tree of annuities has sprouted into several different bloodlines with variations in their structure and use.  Immediate annuities, which are offered through life insurance companies, are the most direct descendent of annua, but its popular cousin, the deferred annuity, shares many of its characteristics along with an additional component that allows for multi-dimensional retirement planning.

Characteristics of Immediate Annuities

For investors, immediate annuities are a form of insurance to protect them against the risk of living too long, beyond their income sources. While Roman citizens weren’t expected to live much beyond the age of 30, today’s retirees are expected to live into their 80s, and many of them are concerned with the adequacy of their income sources.

The basic structure of an immediate annuity is fairly simple: When a lump sum deposit is received by the life insurer, it calculates the amount of money that can be paid over a period of time assuming a certain rate of interest, sort of like a mortgage payment plan in reverse.  If period of time is to be the lifetime of the investor, the life insurer uses actuarial table to determine the the number of payment periods for the investor’s life expectancy.  Should the investor live beyond life expectancy, the insurer is obligated to continue the payments for as long as he lives. This is the insurance component of immediate annuities.

Immediate annuities should be considered by anyone who needs an immediate source of income, and who has concerns as to how long their income sources will last.  Because the income is guaranteed and predictable, immediate annuities are also used to stabilize an income portfolio that might include more risk oriented investments such as bonds or dividend paying stocks. 

Characteristics of Deferred Annuities

During the Great Depression, as the banking industry was crumbling, people turned to life insurance companies for their security needs including saving for the future.  It was then that life insurers began to allow individuals to sock away their savings into annuities before they needed the income.  So, deferred annuities derive their name from the deferral of income until a later date when it is needed.

Essentially, a deferred annuity is no different than an immediate annuity except that it includes an accumulation component at the front end.  The funds that are deposited reside in an accumulation account that is credited annually with a rate of interest.  Because annuities are treated similarly to qualified retirement plans in the tax code, the earnings in the accumulation account are not currently taxed which allows them to grow faster than an equivalent taxable account.

As with qualified retirement plans, the IRS wants to make sure that annuities are used for their intended purpose, as retirement vehicles, so it will assess a penalty of 10% on any withdrawals made before age 59 ½. Still, investors are allowed to make withdrawals from their accumulation account if they need access to the funds. As long as the withdrawals don’t exceed 10% of the account value, they won’t be charged a surrender fee. 

Deferred annuities are ideal accumulation vehicles for investors seeking tax advantaged growth of their retirement funds in addition to their qualified retirement plans.  The advantage of accumulating funds in a deferred annuity is that, at any point, it can be converted into an immediate annuity. In essence, investors can easily transition from guaranteed accumulation period to guaranteed income, thus extending the deferral of taxes throughout the payment period.

Apples and Oranges or Two Peas in a Pod?

Since immediate annuities are best suited for people who need an instant source of income, and deferred annuities are more appropriate for people with time to save, the two vehicles are generally thought to be separate and distinct in the realm of retirement planning.  But, for investors who plan strategically, both types of annuities can be utilized effectively to create a more secure and stable retirement future.

Creating a Ladder of Income

Because no one can predict the future, it is important to have some flexibility in your retirement income plan that can adjust to changing circumstances, yet still provide the essential guarantee of predictable, stable income for as long as it is needed. Using the best characteristics of both immediate annuities and deferred annuities together in an income strategy can generate maximum income without sacrificing security.

Pairing an immediate annuity with a deferred annuity, a strategy referred to as a “split annuity” can create a ladder of income that takes advantage of the guarantees and favorable tax treatment of both.  Instead of depositing the complete lump sum into an immediate annuity to generate a lifetime income, the deposit is split with a deferred annuity.  A specified payment period of, say, 10 years is selected for the immediate annuity, so that the entire annuity balance, both principle and interest, is paid out over the ten years. 

The second part of the deposit is left to accumulate within a deferred annuity so that it grows to amount equal to the original deposit within the immediate annuity. And then the process is repeated.  The result is a higher net monthly income due to the fact that the majority of it is a return of principle.  Meanwhile, the deferred annuity, with its tax deferred accumulation account, rebuilds the principle that is then converted into an immediate annuity. Split annuity strategies can be somewhat complex involving certain assumptions and calculations that should be considered with the guidance of a financial professional.

*This content is developed from sources believed to be providing accurate information. The information provided is not written or intended as tax or legal advice and may not be relied on for purposes of avoiding any Federal tax penalties. Individuals are encouraged to seek advice from their own tax or legal counsel. Individuals involved in the estate planning process should work with an estate planning team, including their own personal legal or tax counsel. Neither the information presented nor any opinion expressed constitutes a representation by us of a specific investment or the purchase or sale of any securities. Asset allocation and diversification do not ensure a profit or protect against loss in declining markets. This material was developed and produced by Advisor Websites to provide information on a topic that may be of interest. Copyright 2021 Advisor Websites.