What is a Deferred Annuity?
- Daniel Kurt
- Jun 8
- 5 min read
Main takeaways
Deferred annuities let money grow tax-deferred and convert it into a future income stream—often a larger one if you wait.
The type of annuity you choose (fixed, variable or indexed) directly impacts growth, risk and eventual payouts.
Deferred annuities can provide lifetime income, but tradeoffs like fees, taxes and limited liquidity need to be weighed carefully.
As diligent as you may be about putting away money for retirement, you may worry about outliving your assets if you’re fortunate enough to enjoy good health. That’s where turning some of your assets into an annuity can be an effective solution. You’re essentially getting a paycheck that you know will be there for the rest of your life.
If you won’t need to receive payments right away, a deferred annuity, in particular, may be a product you’ll want to check out. By delaying your payday, you’ll end up receiving a bigger monthly check when you actually need the cash.
What is a deferred annuity?
An annuity is a contract you purchase from an insurance company, granting you the right to receive a regular series of income payments. Some of them—immediate annuities—start making those payments to you right away.
Deferred annuities, however, delay when you start receiving your stream of payouts. Depending on how you structure the contract, you can defer the payout phase of the annuity for years, or even decades after you fund it.
Once you fund your annuity, with either a lump sum of cash or ongoing contributions, your funds grow on a tax-deferred basis. And because deferred annuities give your balance more time to grow, you end up getting bigger payouts than you would with an immediate version.
While you can choose a contract that only provides income for a specific length of time, most insurers give you the option to receive lifetime payments. That can make them an effective way to manage longevity risk—the chance that you live long enough that you run out of money. With a lifetime annuity, you know you’ll have money coming in every month, or every year, no matter how many birthdays you celebrate.
How fast does a deferred annuity grow?
The rate of growth on a deferred annuity depends on the type of contract you purchase. Among the most common versions are:
Fixed annuities that promise a fixed, relatively conservative rate of growth based on market conditions when you buy the contract.
Variable annuities that credit your balance based on the performance of mutual fund-like subaccounts. While you have a greater growth potential than a fixed annuity, your account value can drop if the market experiences a downturn.
Fixed indexed annuities that offer interest based on the performance of a securities index like the S&P 500. However, your account is guaranteed not to lose value, even if the index underperforms in a given year. In order to provide that protection, the insurer caps the rate of return, resulting in lower returns when the market is performing well.
Example of a deferred annuity
Because deferred annuities give your money more time to grow than an immediate annuity, the same investment amount generally results in larger payments to you during the payout phase. That difference is particularly significant in the case of a lifetime payout because the insurer is making fewer total payments to you.
Take a 65-year-old male who purchases a fixed annuity with a lump sum of $50,000. As of this publication date, the individual would start receiving income payments of roughly $1,471 per month for the rest of their life if they select a 15-year deferral period.*
But if he chooses an immediate annuity with the same lump sum? His contribution has less time to grow and he has a longer payout phase, resulting in a much lower estimated monthly payout of $326.
Typically, the longer the amount of time you choose to delay the payout phase, the larger the difference will be. With a variable annuity, however, there’s always a possibility that the account could lose value after you purchase the contract, which will affect the payments you eventually receive.
What are the pros and cons of a deferred annuity?
While a deferred annuity can be a useful way to help guarantee your income throughout retirement, it’s important to understand both the advantages and potential disadvantages before choosing to buy one.
Pros
You’re essentially getting a paycheck for life when you buy a lifetime annuity, providing the peace of mind that you won’t outlive your wealth.
Annuities provide tax-deferred growth, allowing for larger after-tax earnings than non-retirement accounts.
The lack of a contribution limit means you can put in as much after-tax money as you want, unlike IRAs and 401(k)s.
Cons
Liquidity can be an issue because most contracts will charge a surrender fee if you withdraw more than the allowable limit (often 10% a year) within the first five to ten years.
Payouts from the insurer are treated as ordinary income, so you could be paying more than the capital gains tax that applies to traditional brokerage returns.
Costs can add up, especially for variable annuities that charge mortality and expense (M&E) fees and investment management fees. Adding option riders to your annuity only raises the price tag.
How are deferred annuities taxed?
Money you put into a deferred annuity accumulates on a tax-deferred basis, so you don’t pay the IRS a dime on any interest or investment gains while money is growing. Nothing is being skimmed off each year, so everything compounds faster.
How your income payments are treated depends on whether you paid for the annuity with after-tax money or pre-tax dollars (i.e. the annuity is tucked inside a retirement plan). When you pay with after-tax funds—what are known as “non-qualified” contributions—your earnings are taxed as ordinary income.
The tax code uses something called an “exclusion ratio” to figure out which portion of your payout is your non-taxable principal (your basis) and which part is your taxable earnings. That way, you’re spreading out your tax liability over time.
If you buy the annuity with pre-tax money, or “qualified” contributions, the entire payment from the insurer is subject to ordinary income taxes. Since there’s no cost basis to parse out, the exclusion ratio doesn’t apply.
As with retirement accounts, the IRS gives you a big incentive to keep your money in the annuity until at least age 59½. If you tap into your contract before then, the taxable portion of the distribution is also subject to a 10% early withdrawal penalty, unless you qualify for an exception.
The upshot
Deferred annuities aren’t a one-size-fits-all solution, but they can play a powerful role in turning long-term savings into reliable retirement income. The key is understanding the tradeoffs. When used thoughtfully, they can help transform uncertainty into a steady, predictable paycheck.
*Assumes a single-life annuity contract. Annuity returns can vary based on insurer and market conditions.
