once said that compound interest was the eighth wonder of the world. Understanding this important concept could have the biggest impact on your financial success or failure in life. A fundamental premise of compound interest is that it works best over time and without interruption.
Deferred annuities can provide their holders with the ability to accumulate savings over time, with the option of recovering those funds either as one lump sum in the future, or as an ongoing stream of lifetime income payments over time at a future date.
Deferred annuities are divided into two types. Click Here to continue reading.
Each of these offers differing features and benefits, such as:
- Fixed Deferred Annuities – A fixed deferred annuity will offer a guaranteed rate of return through the life of the annuity contract. Often, fixed annuities are considered to be safer than variable annuities because they not only guarantee a minimum amount of income, but also safety of principal.
- Variable Deferred Annuities – Variable deferred annuities invest their funds into a component that is referred to as a “separate account,” or subaccount, where the annuity holder can participate in market gains. These annuities can also carry risk, as the funds are subject to potential market downturns. Unlike IRA accounts, variable annuities do not have income or contribution limits that dictate how much the account holder may deposit each year.
There are several advantages to owning a deferred annuity. These can include:
- Accumulation – Deferred annuities provide income payments that do not begin until a time in the future. Therefore, the holder of this type of financial vehicle will typically have time – sometimes many years – in which to make deposits and to accumulate a larger amount of money for retirement.
- Tax Deferral – One of the biggest advantages to owning an annuity is the tax deferral benefit. With an annuity, funds inside of the account are allowed to grow on a tax deferred basis and are therefore not taxed until the time of withdrawal. This can allow funds to grow exponentially.
- Variety of Income Options – Deferred annuities also provide a number of different income options – including an option for lifetime income that will literally pay out an income stream for the remainder of the recipient’s life. Oftentimes, annuity holders will choose the joint lifetime income option where the annuity will pay out income for the remainder of two income recipients’ lives. This can be a great way to ensure that two spouses each have guaranteed income that lasts throughout the lifetimes of both.
- Guarantees – Unlike investing in stocks or mutual funds, deferred annuities typically offer a death benefit option by which a named beneficiary can receive funds from the account that were not yet distributed to the annuity owner prior to his or her death. In addition, other types of guarantees may also be added, such as inflation protection that increases the income payments by a certain percentage each year.
Why purchase a deferred annuity?
There are a variety of reasons why investors should consider purchasing a deferred annuity. These include:
Deferral of Tax on Earnings Growth. Because deferred annuities allow investors to postpone their taxes on interest until a future point in time, earnings can accumulate exponentially. This essentially means that money can grow faster over a shorter period of time, ultimately providing you with a greater amount from which to base your future retirement income stream.
As an example, take an investor who is in the 28% income tax bracket who deposits $25,000 into an account that earns 6% interest per year. Each year at 6%, the tax- deferred account will grow by the full $1,500 ($25,000 X 6% growth each year), whereas in the taxable account, $420 of that $1,500 is being eaten away by taxes ($1,500 growth X 28% tax = $420). This leaves the investor with only $1,080 in annual growth in the account.
After 25 years, the investor’s $25,000 would have grown to $71,996 in a taxable account. However, it would have grown to nearly $107,297 in the tax-deferred account – a difference of more than $35,300!
Taxable versus Tax Deferred Investment
- Safety of Principal. Investors’ principal is also safe in a deferred annuity. Because the underlying insurance company is required to meet certain contractual obligations to you, the annuity holder, the reserves that are held by the insurer must at all times be at least equal to the withdrawal value of your annuity, plus additional policy holder protection.
- Avoidance of Probate. Deferred annuities offer additional benefits as well, such as avoidance of probate. If an annuity holder should pass away while still accumulating funds in the annuity account, the funds may be passed on to a named beneficiary (or beneficiaries) – which will avoid the probate process. The beneficiary will be able to either take these funds in one lump sum payment, or they may opt to receive the funds in monthly income installments.