A deferred annuity is a contract purchased from a financial institution, usually an insurance company. The most attractive benefit of these contracts is their tax-deferred status, which prevents taxation from occurring until after the funds are withdrawn or annuitized. This allows the contract’s value to grow at a faster rate, using compound interest, providing the purchaser with a secure place for their money to grow. The growth potential of these annuities is dependent on the type of contract purchased and the credited interest rate.
How does a deferred annuity work?
There are annuities that have multi-year guarantees and some that are variable based, where growth is linked to the investment market or market index (such as the S&P 500). Premium payments can also differ depending on the type of contract. Single premium contracts will normally allow one payment to be made, while flexible premium contracts allow for multiple contributions. Annuities can be purchased as either qualified or non-qualified contracts, giving the owner the opportunity to start an IRA*.
What happens when an annuity matures?
The owner of the contract will normally have the choice of withdrawing the funds, transferring the funds into another contract, or annuitizing after the contract’s term is up. Some annuities may allow the owner to leave the funds in a liquid state while they continue to accrue interest at a rate set by the company. Most contracts contain surrender charges for withdrawing the funds before a specified term has been completed. The typical purpose of a deferred annuity is to accumulate funds with tax-deferred growth. However, some choose to annuitize their contracts. Annuitization is the process of converting an existing annuity into a sequence of predetermined payments for life, or a specified number of payments.
So, what is an annuity? In short, an annuity is a contract that can be used to accrue interest and potentially provide an annuitant with a steady stream of income. The contract’s growth is dependent on the type of contract purchased. Someone looking to purchase an annuity should ask themselves a few simple questions before deciding on which type of product to use. Examining your tolerance for risk, desire for growth and need for liquidity is a crucial first step in this selection process.
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*IRA contracts are not available to all individuals, for more information contact your local financial advisor.
The information presented above is for informational purposes only.