Immediate and Deferred Annuities: What’s the Difference?

An immediate or a deferred annuity can furnish you with additional income when you retire. Learn their differences and how to choose.
By Chris Kissel

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As retirement grows nearer, the thought of living without a steady income becomes scarier to some people. One way to ensure regular payments for the rest of your life is to purchase an annuity. In particular, you can choose between an immediate annuity or a deferred annuity.

These retirement insurance plans offer the peace of mind of a steady income without the worry of excessive market risks. Read on to find out if one of these options might be a good fit for you as you plan your retirement.

What Is an Immediate Annuity?

An immediate annuity is a retirement insurance plan in which you pay a lump sum of money to purchase an annuity that promptly pays you an amount of income on a regular basis, usually for the rest of your life.

In most cases, payments start within about a month of your paying the lump sum. In other cases, they may start up to one year after the purchase.

Many people purchase this type of annuity as a supplement to the retirement income they receive from Social Security and other sources.

Immediate annuities come in two flavors – fixed and variable.

How does it work?

With a fixed immediate annuity, you pay a lump sum to purchase the annuity. The institution that sells you the annuity then agrees to pay you a specific amount each month for as long as the annuity remains in effect.

You can also purchase a variable immediate annuity, in which the amount of income you receive will vary depending on how the investments you choose perform.

Usually, payments begin within one year of purchasing the annuity. Although many people opt to receive payments monthly, other options — such as quarterly, annually, and semi-annually — might be available.

What is it for?

People typically purchase an immediate annuity to supplement the income they receive from Social Security, pensions, and other retirement income sources. Fixed immediate annuities often appeal to those who want the security of a steady income without worrying about the ups and downs of the stock market.

Who is it good for?

Purchasing immediate annuities may be a smart decision for those who want the certainty and security of getting a regularly scheduled payment regardless of what other kind of chaos is occurring in their personal lives or in the wider world.

Pros and cons

To many, the biggest pro of an immediate annuity is its dependability. If you purchase a fixed immediate annuity, you will get a steady income that does not waver, regardless of how investment markets are performing.

Immediate annuities also come with tax advantages. You only have to pay taxes on the part of the immediate annuity payments that are considered earnings. You do not owe taxes on the principal, because you already paid taxes on this money when you earned it.

The downsides of immediate annuities are that in many cases, they are not indexed for inflation. So, payments that seem large in the beginning may become worth less and less over time, particularly if inflation is stubbornly high. With some immediate annuities, you can purchase with inflation protection, but you usually will pay a cost for doing so.

Immediate annuities may not be a good option for certain types of people. For example, having to pay a lump sum to purchase the annuity may mean you have less cash on hand for emergencies and other expenses that crop up in the short term.

Finally, once you purchase an immediate annuity, you lose all control over the lump sum of money you used to purchase the annuity. That means you cannot use that money to invest in the stock market — possibly garnering much higher returns than the annuity provides — to purchase real estate, or for any other use.

What Is a Deferred Annuity?

A deferred annuity is a type of retirement insurance plan in which the value of your account builds over time, and eventually, you can tap into the money in a way that provides you with a steady stream of income during retirement.

The chief way in which a deferred annuity differs from an immediate annuity is that in the former, you are delaying the period between the time you sign the annuity contract and when you actually start to receive payments from the annuity.

During this period of deferral, you can slowly add funds to the annuity so it grows in size, giving you even more money to tap into later.

How does it work?

As with an immediate annuity, you can purchase a deferred annuity with a lump sum. Or, you can make a series of payments over time to gradually build the value. In some cases, you also can use a combination of these two approaches.

Regardless of which approach you choose, you will not receive a stream of income from your annuity right away. Instead, you typically will convert the money in the account into an income stream at a later date. Or, you can have the money paid out in a lump sum.

Unlike with an immediate annuity, you will still have access to your money for the period before you convert it to an income stream. If you so choose, you can even surrender your contract, which allows you to get the money back, minus your surrender fees.

Who is it good for?

As with an immediate annuity, a deferred annuity is a good option for those who want a steady stream of income in retirement to supplement other income sources.

A deferred annuity also can be a good option for those who have maxed out retirement contributions to a 401(k) or IRA plan and are looking for other places to save. Unlike those other types of retirement savings plans, there are no limits to the amount of cash you can put into a deferred annuity.

Pros and cons

As with an immediate annuity, you do not have to pay taxes on the money in your deferred annuity account until you withdraw the money.

In addition, a deferred annuity comes with a death benefit. When you die, any remaining funds and investment earnings go to your heirs, minus any cash withdrawals you have made.

One of the biggest potential drawbacks of a deferred annuity is the fees that come with it. These include administrative fees, funding costs, and commissions. You also may pay additional charges for special features and riders you select.

Also, although you will have access to your money in the period before you convert it to an income stream, you may owe surrender charges on any money you withdraw. You also may owe a penalty to the IRS for any funds you withdraw prior to turning age 59 ½.

Immediate or Deferred Annuity: How Should You Choose?

Whether you should buy an annuity, whether immediate or fixed, depends on your financial situation, risk tolerance, and overall retirement goals. Everybody is different, and you should carefully assess your own situation before moving forward. You can use a retirement calculator to determine how much money you’ll need during retirement. This is an important step in deciding which retirement investments are best for you.

When an immediate annuity might be for you

This type of annuity can make sense if you have enough liquidity to cover short-term expenses but want the security of getting a regular payout for the rest of your life without having to worry about market risk.

When a deferred annuity might be for you

This type of annuity might make sense if you have maxed out other retirement savings options and want a place to save money tax-deferred for a period before you tap into the money during retirement.

About Author
Chris Kissell the founder of Words At Work, LLC, a writing, editing and consulting company based in Colorado. He was previously a senior editor at Bankrate and senior managing editor at Insurance.com. He's written for and worked closely with U.S. News & World Report, GOBankingRates, CreditCards.com, and many other websites and publications.