Deferred Annuity
A deferred annuity is an insurance contract in which the owner makes one or more premium payments that accumulate on a tax-deferred basis, with income payments beginning at a future date — either through systematic withdrawals or annuitization.
Deferred annuities separate the savings phase from the income phase. During the accumulation period, the owner's premium payments grow inside the contract sheltered from current income taxation — dividends, interest, and capital gains are not reportable until funds are withdrawn. This tax deferral allows the account to compound at a faster rate compared to a taxable account holding identical investments, particularly over long time horizons.
Deferred annuities can be funded through a single premium (a one-time lump sum) or through flexible premiums paid over time. They are available in fixed, variable, and fixed indexed forms, each with different risk and return characteristics. The contract typically specifies a surrender charge period during which withdrawals exceeding the free-withdrawal amount (commonly 10% of the account value per year) trigger a percentage penalty that declines over time — for example, 7% in year one, declining by one percentage point per year until it reaches zero.
When the owner is ready to transition from accumulation to income, several options exist. Annuitization converts the account value into a guaranteed stream of periodic payments under one of the payout options described in the contract. Systematic withdrawals allow the owner to take regular distributions without annuitizing, preserving the ability to access the remaining account balance or change the withdrawal amount. Many modern deferred annuities also include optional income riders — added for an annual fee — that establish a guaranteed withdrawal benefit regardless of investment performance.
Under IRC Section 72, earnings withdrawn from a non-qualified deferred annuity are taxed as ordinary income under the LIFO rule — earnings come out first and are fully taxable, before any return of principal. Withdrawals before age 59½ are also subject to a 10% additional tax. Transferring a deferred annuity from one insurer to another without triggering a taxable event is possible through a 1035 exchange, a provision in the Internal Revenue Code that allows the tax-deferred status to carry over to the new contract.
The SECURE 2.0 Act of 2022 included several provisions affecting deferred annuities within employer plans. It expanded the ability of plan sponsors to include annuity options in 401(k) menus and created a safe harbor for plan sponsors who select annuity providers, reducing fiduciary liability concerns that had historically discouraged the inclusion of annuities in defined contribution plans.