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What is a 'Deferred Annuity'

A deferred annuity is a type of annuity contract that delays income, installment or lump-sum payments until the investor elects to receive them. This type of annuity has two main phases: the savings phase, which is when you invest money into the account, and the income phase, which is when the plan is converted into an annuity begins paying the account owner. A deferred annuity can be variable or fixed.

BREAKING DOWN 'Deferred Annuity'

A deferred annuity is a contract between an individual and a life insurance company in which funds are exchanged for a promise to provide a competitive interest rate with a minimum interest rate guarantee. The contract also guarantees the principal investment. Because annuities are classified as nonqualified retirement instruments, they receive a tax benefit in the form of tax deferral on earnings. Earnings are taxed as ordinary income upon withdrawal or annuitization.

How a Deferred Annuity Works

When funds are deposited with a life insurer, they are credited to an accumulation account in the annuity owner's name. The life insurer then credits the account balance with a fixed interest rate. In most cases, the fixed interest rate is guaranteed for one year to 10 years. When that period expires, the insurer resets the interest rate, typically for one-year periods. Most annuity contracts include a minimum rate guarantee that ensures the interest rate the account receives never falls below a certain minimum, regardless of the economic climate at the time. 

Withdrawals are allowed in most contracts with certain limitations. In a typical contract, the withdrawal provisions allow for one annual withdrawal. If any withdrawal exceeds 10 percent of the account's value, the insurer charges a surrender fee on the excess. The fee can range from 7 to 15 percent on a declining schedule. Each year, the surrender fee drops by one percentage point until it reaches zero. At that point, the surrender period ends, and the annuity owner can withdraw funds without penalty. However, withdrawals are taxed as ordinary income, and withdrawals made prior to age 59 ½ are subject to a 10 percent penalty. A deferred annuity can be annuitized to provide guaranteed income payments for a set period of time or for life of the annuitant.

This type of annuity also includes a death benefit component that ensures the beneficiaries receive no less than the principal investment plus any gains in the account. The death benefit proceeds are taxable to the beneficiary as ordinary income.

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