Definition of Deferred Annuity
A deferred annuity is a mechanism to supplement retirement income. It is a contract between the insurance company and the buyer as per which the buyer has to make a regular contribution towards the annuity plan and can receive the return in the form of monthly income or as a lump sum after the retirement.
A deferred annuity is further bifurcated into two phases i.e. investment phase and income phase. The investment phase begins when the buyer starts making a contribution or a lump sum contribution in the annuity plan and continues until the point of their last contribution. And income phase begins after the retirement of investors that is from the point when they start receiving the monthly income or lump sum whichever option they have chosen.
The contribution to the deferred annuity is allowed for taxation purpose but the return is taxed by the IRS (internal revenue service). If the investors have to avoid the penalty of 10% on early withdrawal they will have to wait till the age of 59.5 years before withdrawing anything. In case of the death of the investor, the beneficiary will get the remaining funds in the annuity.
How Does It Work?
Below is the step wise step explanation of the working of the deferred annuity:
- Step 1: It is the contract between the insurance company and the buyer.
- Step 2: The buyer has to make a regular contribution or a one-time lump sum contribution in the annuity.
- Step 3: After the retirement investors can choose to receive regular monthly income, a lump sum benefit or they can annuitize their annuity fund to receive regular payment till death.
- Step 4: The contribution to the annuity fund is allowed for taxation purpose but the income received after the retirement is taxed by the IRS (Internal revenue service.)
- Step 5: The annuity plan is used as a supplementary retirement income by the buyers.
The formula of Deferred Annuity
The formula of a deferred annuity is as follows:
Deferred annuity on the basis of ordinary annuity i.e. payment is done at the end of each period is as follows:
- P ordinary = ordinary annuity payment
- r = Effective Interest rate
- n = No. of Periods
- t = Deferred Periods
Deferred annuity on the basis of the annuity due i.e. where the payment is done at the start of each period is as follows:
P due = Annuity payment due
The rest is the same as above.
Example of Deferred Annuity
Let us take an example where an investor purchased a deferred annuity in which he has to invest $90,000 and will get 30 payments of $9,000 each annually post-retirement. The effective rate of interest is 4.5%, the no. of the period after which the annuity payment will start is 10 also.
Deferred Annuity = $9,000 * [1 – (1 + 4.5%)-30] / [(1 + 4.5%) 10 * 4.5%]
|Payment in a year||1|
|Effective rate of interest (r)||5%|
|No. Of deferred period (t)||10|
|no of period (n)||30|
Types of Deferred Annuity
There are three types of deferred annuity:
- Fixed annuity: In this type of annuity, the rate of interest is fixed and never changes. But it does have a lower rate of return in comparison to other types of annuities.
- Variable annuity:In this type of annuity, the funds are invested in a variety of investment options like stocks bonds, etc. It provides a potential higher rate of return and is associated with high risk as well.
- Indexed annuity: In this annuity, the minimum rate of return is guaranteed like in fixed interest annuity but the rate can go up determined by the market index.
Uses of Deferred Annuity
The uses of deferred annuity are as follows:
- Deferred annuity serves as a supplementary retirement income.
- The annuity can buyer can get tax benefit on the contribution payment on a deferred annuity.
- The buyer can enjoy the peace of monthly regular income if that is what they choose through the deferred annuity option.
The advantages of deferred annuity are as follows:
- The contributions towards deferred annuity payment are allowable for tax benefit purposes.
- There is no annual contribution limit for payment towards the deferred annuity.
- The buyer can choose to receive monthly steady income post-retirement or a lump sum amount after retirement.
- Deferred annuity helps buyers in planning their retirement in a comfortable manner.
The disadvantages of the deferred annuity are as follows:
- The return of the deferred annuity post-retirement is taxable.
- If a person withdraws the money before a stipulated period of time, they will have to give a 10% penalty.
- The annuity providers charge hefty commission at the time of selling the funds to the investors.
- Some deferred annuities have high annual fees for their maintenance purpose.
The crux of the matter is that the deferred annuity is a very good option to enhance the retirement income and helps a lot in planning life after retirement. Though it does have some minus point like every other thing in the world, it’s very purpose and benefits overshadow the impact of disadvantages or limitations.
This is a guide to Deferred Annuity. Here we also discuss the definition and how does deferred annuity work? along with advantages and disadvantages. You may also have a look at the following articles to learn more –