Persia Insurance Group

There are two basic types of modes of accumulation and distribution in annuities, Immediate and Deferred. Their names go a long way in explaining how they work, but understanding both the similarities and differences between the two is important to any investor considering an annuity.

The Basics

An Immediate Annuity is an annuity that is payable within a very short period of time after an account has been opened. Typically, a lump sum of money is deposited into an account and then it is distributed back to the depositor in specific amounts at specific intervals.

As an example, let’s say an investor has just retired and has received $240,000 from the 401k he had with his employer. He wants to utilize that money as an income stream for his retirement. If he chooses to invest it in an Immediate Annuity, he will be taking the money from his 401k and placing it an interest bearing account. He then must decide how often he wants to distribute the money back to himself and in what monetary increments. He can choose to spread out the re-distribution over a fixed period of time, say 10 or 15 years, or over the remainder of his lifetime. Either way his deposit gains interest and he can access his account usually within a month after it was opened.

A Deferred Annuity is an annuity that is paid into over a longer period of time. An investor may choose to place $100 a month in his annuity for 20 years. He would, before interest, end up with the same $240,000 as the investor in the previous paragraph (240 months X $100). Of course, he can deposit more or less money and do it over a longer or shorter period of time. He can base his deposits over a defined length of time or he can choose to deposit money until his account reaches a certain amount total. These variables will affect the interest rate he receives on his deposits.

Benefits and Costs

The benefit of a Deferred Annuity is that it allows for flexibility in the case of the depositor. It is very user friendly in that it can be customized to meet different financial and chronological needs. The trade off is that there will be a level of uncertainty in the rate of return.

Conversely, the Immediate Annuity is inflexible in that it is locked in to a particular rate of interest and rate of repayment. But the recipient of an Immediate Annuity has a greater level of certainty than the recipient of a Deferred Annuity.

To Each His Own

The Immediate Annuity is perfect for someone who wants to have stability in his income stream during his retirement and is able to invest a reasonably large sum of money at one time. As mentioned above, it is common for people who have cashed out their 401k to then convert the proceeds from that into the guaranteed income that comes with the Immediate Annuity.

Another group of people besides recent retirees who often utilizes Immediate Annuities are the beneficiaries of a lawsuit and lottery winners. Generally, any person with a lump sum that they would like to use it as income protection for their later years.

The Deferred Annuity is a great option for people who are unable to invest a large amount of money at one time and those far from retirement. Many people who are still in the workforce utilize the Deferred Annuity as a tool for their retirement planning. Investors who opt for the Deferred Annuity can take advantage of high interest rates over the course of many years whereas investors with an Immediate Annuity are subject to the interest at the time of their lump sum deposit. Still, it is entirely possible that a person could take the money earned from a Deferred Annuity over the course of 15 or 20 years and later invest it in a product that guarantees income, such as the Immediate Annuity. In fact, this is a typical retirement strategy.

Distribution

While the way money gets into an annuity is straightforward—it’s either a lump sum or contributed over time—the way it’s distributed back to the account owner can vary considerably. Many people link their annuity to a death benefit. For example, if there is still money remaining in their account at the time of their death, the account owner may have attached a rider to their annuity that acts as a provision for the re-distribution of the funds. The term Period Certain refers to a death benefit from an annuity that is to be paid out over a fixed period of time.

Some people simply take their distribution and then re-invest it in a whole life insurance policy rather than wait for a death benefit.

These examples are merely the tip of the iceberg as there is a seemingly endless array of strategies available for investors when it comes to distributing the funds from their annuity.

Taxes

From a taxation standpoint, the Deferred Annuity is preferable to the Immediate Annuity if only because along with deferring income it also defers taxes.

Once the money from an annuity is distributed, the income portion is still taxed as regular income and the corresponding rate. Deferring taxes until retirement is good tactic since most people won’t be in their highest earning years and subject to the rate of taxation they were while they were still working.

As with most investment planning tools the IRS wants to do everything it can to motivate taxpayers to keep money in their retirement accounts. The way they motivate people with annuities is by taxing them at a rate of 10% should they withdraw their funds prior to the age of 59 ½. This is in addition to any fees that the insurance company would charge the account holder for early withdrawal. The IRS places identical disincentives on 401(k) and IRA accounts.

A Final Note

With any annuity there are many factors that can affect interest rates and rates of return, such as the amount and frequency of the deposit and insurance company issuing the contract. Be sure to make use of all the online resources at your disposal to help determine which annuity is right for you.