An annuity is a contract between you and an insurance company, where the insurer will pay you a guaranteed stream of income in exchange for buying the annuity, often for the rest of your life. Your annuity will either be immediate or deferred. The difference between these two types of contracts is when the annuitization or payout period begins.
With an immediate annuity, once you fund your contract, you’ll start receiving payments right away — within 12 months. With a deferred annuity, you won’t receive any payments for at least one year, although it’s common to wait several years or even decades to start receiving income payments.
What is an immediate annuity?
An immediate annuity is a contract between you and an insurance company that starts generating income payments right away. In exchange for the premiums you pay, the insurer promises to provide you with an income stream based on the terms of your contract. With an immediate annuity, your money will be disbursed back to you within 12 months of purchasing your contract.
Immediate annuities are best for people who have a large sum of money and want to use those funds to set up an income stream as soon as possible, such as new retirees looking to manage their retirement savings.
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What is a deferred annuity?
Deferred annuities are also insurance contracts that give you a stream of income in exchange for a premium payment or a series of premium payments. But unlike immediate annuities, with a deferred annuity, there’ll be a delay of at least one year — but usually many years — between the time you pay all of your premiums and the time you start receiving financial benefits from your contract.
Deferred annuities are best for people who have the financial means to fund a contract, but won’t need access to the funds in their annuity for many years.
Learn more about other types of annuities
What are the main differences between immediate & deferred annuities?
Before you purchase an immediate or deferred annuity, it’s helpful to understand the differences between them and how they may align with your needs.
Premiums & accumulation period
Both types of annuities can be paid for in one lump sum or in multiple payments, although immediate annuities are more commonly funded with a large single payment. Deferred annuities, on the other hand, allow you to contribute multiple payments during the time that your funds grow.
The major distinction between an immediate annuity and a deferred annuity is the accumulation period — the time between when your annuity is fully paid for and when the annuity starts paying you.
With an immediate annuity, your payments will start right away — in other words, it doesn’t have an accumulation period.
With a deferred annuity, your payments will start in the future — so this type of contract does have an accumulation period. Technically, a deferred annuity won’t start paying you for one year, but most deferred annuities won’t pay you for several years or even decades.
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Growth
Whether your money is in an immediate annuity or deferred annuity, there are several ways that it can grow, depending on the type of annuity you choose: fixed, indexed, or variable.
Fixed annuities offer a low but guaranteed rate of growth. The insurer will guarantee that your money grows at a certain rate, but your money won’t grow as aggressively as it could with other annuities.
Indexed annuities provide growth that is tied to the stock market. Your money could grow more quickly than with a fixed annuity, but there are limits to how much your money can grow — and how much it could lose during a market downturn. Indexed annuities come with moderate risk and potentially greater returns than fixed annuities.
Variable annuities allow you to invest your funds directly in the market. This type of contract can gain or lose money based on the performance of investments that you choose. Variable annuities are best for people with a high risk tolerance and the ability to choose which companies to invest the annuity in. They offer potentially greater returns than both fixed and indexed annuities, but the potential for losses is also greater.
If your money is in a deferred annuity, it’ll have more time to grow according to how it’s invested. By contrast, an immediate annuity will be less impacted by your investment choices, because you’ll start taking income payments sooner.
Learn more about fixed annuities vs. variable annuities
Annuitization or payout phase
The annuitization or payout phase is similar for both immediate and deferred annuities. You’ll have the option to have your annuity paid out in one lump sum or in several payments over a period of time or for the rest of your life.
Most people elect to receive several payments from their annuity — which can be, for example, monthly, biannual, or annual. These are called income annuities and they can be especially helpful in your retirement years after you stop having an earned income.
Can you withdraw money from your annuity?
Withdrawals & surrender period
With both immediate and deferred annuities, you’ll usually pay fees if you withdraw your money before the agreed-upon payout phase. This is especially true during the surrender period, which often lasts around seven years, but can be longer or shorter.
Surrender fees usually decrease over time during the surrender period — you may pay a higher surrender fee during the first year of your contract than, say, during the third or fifth year.
“The surrender period is usually tied to the commission schedule that the [seller] receives,” says Laura K. Cook, certified financial planner at Flourish Financial Life Planning, LLP. If you try to withdraw funds before the commission is paid for, you’ll have to pay extra fees to the insurer to cover this loss.
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Returns or earning potential
The earnings from your annuity will have more to do with the type of investments you make, and how long you let the annuity grow. By their nature, a deferred annuity will allow more time for your money to grow.
But the real growth potential of your annuity will be determined by whether its growth is fixed, indexed, or variable.
Tax implications
Annuities can be purchased with either pre-tax or after-tax dollars, and you’ll only be taxed once on these funds. You can set up an annuity to minimize the amount of income tax you pay over the course of your lifetime.
Because many people’s retirement income is less than their income while working, getting a qualified annuity can bring a tax break. [1] You can fund a qualified annuity with funds held in a retirement account — for example, a 401(k) plan or an IRA — and you’ll pay taxes when the payments are disbursed to you, which could land you in a lesser tax bracket and allow you to keep more of your money.
You can also fund an annuity with after-tax dollars — using savings, the sale of a large asset, or even proceeds from a windfall, like a lottery win. In that case, you’ll be buying a non-qualified annuity.
Another key difference between qualified and non-qualified annuities is that qualified annuities have contribution limits and distribution rules set by the IRS as they’re considered tax-deferred retirement accounts. Non-qualified annuities don’t have contribution or distribution limitations.
Riders
In most cases, you’ll have the option to add riders to your annuity. Riders are optional add-ons to your annuity that offer more robust coverage, often for a fee. Some common annuity riders are:
Cost of living adjustment (COLA) rider. It allows your income payments to adjust with inflation. If you’re worried about your income payments losing value over time due to high inflation, a COLA rider can be a good fit for you.
Return of premium rider. It returns any remaining principal to your chosen beneficiaries if you die before the full value you paid for the annuity has been paid back to you. If you’re worried about passing away before the annuity fully pays out, you should consider this rider.
Guaranteed minimum withdrawal benefit rider. It allows you to withdraw the initial amount you paid incrementally each year, based on a certain percentage, until you’ve withdrawn the entire amount. This rider can be useful if you’re worried you may need to withdraw the annuity funds early, or if you’re worried that your funds will lose value during a market downturn if you bought a variable annuity.
Learn more about how annuities work
Immediate vs. deferred annuities: Comparing the main differences
Feature | Immediate annuity | Deferred annuity |
Premiums | Usually paid for in one lump sum | Single or multiple premiums |
Accumulation period | Less than 12 months | More than 12 months |
Annuitization | Immediate | At least one year |
Penalty for early withdrawals | 10% penalty plus taxes | 10% penalty plus taxes |
Surrender period | Varies, usually around 7 years | Varies, usually around 7 years |
Investment options | Fixed, indexed, or variable | Fixed, indexed, or variable |
Tax-deferred options | Yes | Yes |
Rider & benefit options | Yes | Yes |
How to decide between immediate & deferred annuities?
If you’re considering an annuity, deciding between an immediate annuity and a deferred annuity is mostly a matter of timing. If you need the payments from your annuity in the near future, an immediate annuity will better meet your financial needs. If you’re planning ahead for the future and you can afford to let your funds accumulate value, a deferred annuity will be a better fit.
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Who should consider an immediate annuity?
If you have a large sum of money and want to set up a steady income stream right away, setting up an immediate annuity may be a good financial move. These types of annuities are especially helpful if you want to manage your money in a way that involves limited administrative oversight.
People who usually fit this description are retirees who want to organize their retirement accounts to distribute their savings in a sustainable way. “These are clients without other sources of guaranteed income,” says Kyle Newell, owner of Newell Wealth Management and a certified financial planner. “Typically [immediate annuities] are used to help cover a portion of basic needs and so you don't have to worry about market fluctuations.”
While retirees are the most common purchasers of immediate annuities, they also can be helpful if you experience a large windfall, such as receiving an inheritance, benefiting from a court settlement, or even winning the lottery, and you’re worried about not knowing how to invest the funds wisely.
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Who should consider a deferred annuity?
You should consider a deferred annuity “if you don’t need annuity payments immediately and want to wait until a later date to receive the payments,” says Tony Boyden, learning partner at Zinnia.
Deferred annuities are best for people who have money that they want to use to fund their retirement, but don’t anticipate needing a supplemental income for at least a year. Deferred annuities allow you to plan for your longer-term financial needs.
If you’re not sure how an annuity could fit in your financial plan, speak with a financial advisor who can offer you transparent, unbiased advice.
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