Tax-Deferred Annuity Definition
An annuity is an insurance policy that pays a guaranteed income to you over your lifetime or for a set number of years. A tax-deferred annuity refers to an annuity that defers your payment until a time you specify. Before buying these financial products, you should understand how they work and how they can work for you.
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Types
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There are two types of tax-deferred annuities. A fixed annuity pays a fixed rate of interest to the annuity savings you deposit into the annuity account. A variable annuity pays an interest rate that is not guaranteed from year to year. In other words, the payment of interest fluctuates.
In both fixed and variable annuities, you may make either a single contribution, or contributions over time. A single contribution annuity is called a single-pay annuity. An annuity that allows multiple contributions over time is referred to as a savings annuity.
Features
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Fixed annuities invest in bonds or bond-like investments. These investments generate income to the insurance company. A part of the investment gain is then credited to your annuity account. Variable annuities use mutual funds to determine the crediting rate of the annuity. Your annuity account value increases or decreases according to the underlying value of the mutual funds in the annuity.
A mutual fund is a collection of stocks or bonds that share a common investment objective. Because bonds in a mutual fund are normally actively traded, the returns are not fixed, and thus are not guaranteed, in the way that bonds in the insurance company's fixed annuity are.
When you retire, you have the option to keep your annuity policy and withdraw money as you need it or you may convert your savings to monthly payments.
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Benefit
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The benefit of a tax-deferred annuity is that you are able to build a retirement savings that is larger than what you otherwise would be able to accumulate if you had to pay taxes on your investment earnings. Additionally, you choose when you want to pay taxes on your savings, since you are not forced to take distributions from your annuity.
Disadvantage
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The disadvantage of a tax-deferred annuity is that, unlike other retirement accounts, you cannot make tax-deductible contributions. Likewise, when withdrawing money, you must pay tax on all investment gains in the policy. When making withdrawals, investment gains are considered to be withdrawn before principal. Finally, instead of paying capital gains tax, as you would with an investment, you pay ordinary income tax. Ordinary income tax rates may be higher than capital gains tax rates, which means you may end up with less money overall from your annuity than if you had invested in an investment directly or if you had used a retirement account.
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