Deferred Annuities vs. Immediate Annuities: What’s the Difference?

Posted by Bill Bruce on Dec 10, 2020 11:00:00 AM


For many Americans, the events of recent years have really highlighted the importance of having reliable income streams to help us fulfill our retirement plans or carry us through times of economic uncertainty. Setting aside an emergency fund for covering large expenses is a good first step, but there are other, more productive uses for large sums of cash that can help you fund your future.

One way to set up an ongoing income stream for the future is to put money into a fund that can grow and pay out at a later date—such as a deferred annuity. Others who come into large sums of money all at once may find benefit in putting that money into an immediate annuity that helps them throttle their spending by locking the money away where it cannot be used up too quickly.

What are annuities? What’s the difference between immediate and deferred annuities? How do they work? What are some things that others have often asked about annuities that you need to know before buying one?

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What Are Annuities?

An annuity is a financial product designed to provide a guaranteed stream of income. An insurance company provides this income in exchange for one or more premium payments, depending on the terms of the annuity contract. The insurance company collects the premiums, and the value of the annuity grows tax-deferred. 

Typically, only the earnings portion of annuity income is subject to tax. However, it is possible to purchase an annuity with qualified (pre-tax) funds, such as through a 401(k) or traditional IRA. In this case, the payments would be 100% taxable as income, since taxes would not have been paid on the income used for premium payments.

Before buying an annuity, however, it’s important to understand when, how, and at what cost you will be able to access its funds. Different types of annuities are bound by different rules, and each insurance company has its own set of rules and fees associated with withdrawals.

We’re sharing general information here, but it’s always important to fully understand the terms of the specific annuity product you intend to purchase. So, reader, please consult with your financial advisor or a certified financial planner (CFP) before purchasing any annuity product. This blog isn’t intended as financial advice, but as a way to help you better understand the options available to you.

What Is a Deferred Annuity?

A deferred annuity can be purchased with either a lump sum or a series of premium payments. These annuities have an “accumulation period” before the insurance company begins making regular payments.

This provides both benefits and risks. On one hand, a deferred annuity has more time to generate interest, providing much more potential for tax-deferred growth. In some cases, you can also choose to make additional payments during the accumulation period. On the other hand, there is a risk that you’ll die during the accumulation period of a deferred annuity.

What happens in that event depends on the terms of the annuity contract, so it’s important that you understand these terms before you buy.

What Is an Immediate Annuity?

When you purchase an immediate annuity, you pay a lump sum to the insurance company up front and begin receiving regular payments soon after. The amount you receive will depend on the premium you paid, your age, the prevailing interest rates, and the number of payments the insurance company expects to make.

This is the more popular choice among those who are already retired or plan to retire soon because it provides the security of an immediate, steady stream of income.

Depending on the terms of the annuity contract, payments may be made for the rest of your life or for a specified period of time. Because payments begin almost immediately, there is little risk that you will die before you start receiving an income from an immediate annuity.

You may also be able to name a beneficiary, who would receive payments or a return of principal if you were to die before all payments have been made. Such provisions may cost extra, however.

woman reviewing types of annuities

Immediate Annuity Vs Deferred Annuity FAQs

To help you better understand annuity products and how annuities work, let’s go over some questions a lot of new annuitants often have about different types of annuities and their benefits.

Some frequently-asked questions about annuities include:

Can I Withdraw Early from an Annuity?

The answer to this question changes based on the type of annuity you’re looking to withdraw from and the terms of the annuity contract. With immediate annuities, you cannot withdraw early from the annuity—the payment schedule is set in proverbial stone at the time of purchase.

However, in many cases, deferred annuities allow the withdrawal of funds ahead of scheduled income payments.

When, how, and to what extent you can take withdrawals from a deferred annuity depends on the terms of the contract you sign. Each contract contains its own rules about withdrawals, but examples of typical provisions include withdrawal of accrued interest and periodic withdrawals of a percentage of either the principal or the entire contract value.

It’s important, however, to understand any fees, penalties, or other costs that are associated with withdrawals. The cost of making withdrawals from a deferred annuity can vary widely from one insurer to the next. Be sure you know the answers to these questions before moving forward with purchasing or withdrawing from a deferred annuity:

Under what circumstances will surrender or withdrawal charges apply?

It’s common for withdrawal charges to apply throughout the contract term, and some companies apply charges for withdrawals even after the term has passed. These charges may decrease over time, so be sure to check the terms of your contract at the time you’re considering a withdrawal.

Will a withdrawal change the interest rate I receive on my annuity?

While there may not be an outright charge for a withdrawal, some insurers adjust the interest rate credited in exchange for electing certain withdrawal features for the annuity. Compare insurers so you can capture the best interest rate for the terms you need.

Will a market value adjustment apply in addition to any surrender or withdrawal charges?

In the event that you need to take more out of your deferred annuity than is allowed free of charge, it’s important to be aware of another potential cost: the market value adjustment. This is a calculation that takes into account both the interest rate that applied at the time your annuity was issued and the current interest rate.

The effect of this adjustment is that when interest rates go up, an additional charge is added to your withdrawal. This can work in reverse, as a decline in interest rates would actually result in an increase in the annuity’s surrender value; however, this result is less common.

couple discussing annuities ahead of retirement

How Does a Deferred Annuity Grow?

Deferred annuities typically grow on a tax-deferred basis. This means that the value of the annuity is only taxed at the time of collection, not as it grows. This enhances the growth of the annuity by allowing more money to remain in the fund with each interest period.

For example, say you had an annuity worth $1,000 and it earned 4% interest. With tax-deferred growth, that’s $40 being added to the fund. If taxed, you could lose anywhere from 10% to 37% depending on the tax bracket you’re in at the time of taxation—meaning you only earn $36 to $14.8 instead of the original $40. This would limit the growth of the money in the annuity fund. Growing tax-deferred avoids this issue and lets the fund consistently accumulate its full growth amount every interest period.

What Is Compound Interest?

Annuities also grow using “compound interest.” This means that any money earned in the annuity fund is then used as a basis for further growth. For example, if that $1,000 fund mentioned earlier didn’t have compound interest, it would only ever earn $40/year. However, with compound interest, it would earn $40 in the first year, then the 4% growth would apply to the new total of $1,040—growing to $1,081.60 in the second year. This is an additional $1.60 of growth.

The bigger the fund, the faster compounded growth can cause it to grow. For example, in ten years’ time, a $1,000 fund would achieve $480.24 of growth—reaching $1480.24 of total value. A $10,000 fund would achieve $4,802.44 of growth in that same time frame—becoming worth $14,802.44.

Delays between initial setup and collection can also increase the impact of compound growth on an annuity. For a $10,000 annuity contract at 4% growth, one year of growth would be $400 of earnings, five years would be $2,166.53 of earnings, and 20 years would be $11,911.23 of earnings—doubling the money put into the annuity.

Can I Pay More into My Annuity Fund to Grow It Faster?

It depends on the annuity in question. Immediate annuities often don’t allow extra contributions since they enter their annuitization phase immediately. Deferred annuities, on the other hand, often allow annuitants to make extra payments before the scheduled annuitization date to increase the value of the fund and potentially increase future earnings amounts when the fund does mature.

What Does Annuitization Mean?

The annuitization phase (or “period”) is the term for when an annuity starts making payments to the annuitant (the person designated to receive funds under the annuity’s contract terms).

For immediate annuities, the annuitization phase begins as soon as the annuity is purchased. Meanwhile, deferred annuities delay the annuitization phase to allow the fund to accumulate more value before the payout begins.

What Does Accumulation Mean for Annuities?

Accumulation period (or “phase”) is a term for describing the time before a deferred annuity starts making payments. During the accumulation phase, you can either make additional payments into the annuity fund to help it grow faster or let it continue to grow passively.

Can an Annuity Help with Qualifying for Medicaid?

Possibly, depending on the annuity and your personal financial situation. Some annuity purchasers can use annuities as a way to accelerate their eligibility for Medicaid benefits. A Medicaid-compliant annuity (MCA) product needs to meet several restrictions, including:

  • Being fixed-term with no life contingencies for a period of time equal to or less than the expected life of the annuitant.
  • Not being able to be sold, surrendered, or assigned to a third party.
  • Being irrevocable with the contract parties being unable to be changed.
  • Having level payments that do not change from inception to completion.

This is partly because to accelerate eligibility for Medicaid benefits, the MCA is “taking away” assets that would otherwise count against the eligibility ceiling for Medicaid benefits.

Using an annuity to qualify for Medicaid is a very complicated task. It is strongly recommended that you consult with a financial advisor or CFP before applying for an MCA to see if it would actually help you meet eligibility criteria based on your specific financial situation.

What Happens if I Die Before Collecting My Annuity?

If you die before you collect part or all of your annuity, what happens to it? That depends on the terms of your annuity contract.

For example, the rather strict terms of a Medicaid-compliant annuity product would mean that the value of your annuity cannot be transferred to an inheritor. Instead, the funds are, as explained by DeLoach Hofstra + Cavonis, PA, “used to pay back Medicaid.”

However, other annuity products may allow you to transfer the value of the annuity (or potentially even the annuity payments) to a designated third party such as your spouse, a blood relative, a charity, or some other entity you designated as the inheritor of your estate.

This all depends on the terms of your annuity contract. So, it’s important to have a financial advisor or a CFP review the terms of the contract with you to highlight any terms that might impact your estate planning.

Have More Questions? Ask ELCO Mutual!

These are just a few of the FAQs about annuities that we’ve heard over the years. If you have a question about annuities that you didn’t see answered here, please contact us with your query. We’ll be happy to help!

Reminder: This blog does not constitute financial advice. Before purchasing any annuity product, be sure to consult with your financial advisor or CFP for help with choosing the best product to meet your needs or alternatives to annuities that may better serve your specific financial situation and goals.More than a policy provider, we're a partner at ELCO Mutual


Topics: Annuities