Saving for retirement often involves choosing tools that help your money grow efficiently. One option is a tax-deferred annuity, which lets earnings build without annual taxation. This can help strengthen long-term compounding and helps you control when you recognize taxable income.
While tax deferral can be a significant advantage, these annuities come with trade-offs like limited liquidity, surrender charges, and ordinary income tax on earnings and in the case of qualified annuities, on contributions as well.
This guide breaks down what a tax-deferred annuity is, its pros and cons, and how to evaluate if it makes sense for your retirement plan.
What is a tax-deferred annuity, and how does it work?
A tax-deferred annuity is a contract between an individual and an insurance company that can combine investment growth with the option for guaranteed retirement income. With this type of annuity, you don’t pay taxes on earnings until you withdraw funds, typically in retirement. This structure differs from taxable brokerage accounts, which can result in annual taxes on interest, dividends, and capital gains.
While an immediate annuity pays out right away, a tax-deferred annuity functions in two stages. During the accumulation period, your money can grow tax-deferred. In retirement, you can convert the contract into a guaranteed income stream.
Several types of annuities offer tax deferral and varying levels of risk and return:
- Fixed annuities: Guarantee growth at a fixed interest rate.
- Indexed annuities: Link interest crediting to a market index, with downside protection. Also known as equity-indexed annuities (EIAs).
- Variable annuities: Use market-exposed subaccounts similar to mutual funds.
- Deferred income annuities: Promise income starting at a future date.
These tax-deferred annuities share one feature: You don’t pay taxes until you withdraw money.
How tax deferral works
Tax deferral lets your money grow year after year without paying income tax on earnings, including interest, dividends, and capital gains. This can enhance compounding — the process of earning money on your principal plus accumulated interest. The U.S. Securities and Exchange Commission (SEC) has a useful calculator that visualizes the power of compound growth.
To see the impact of tax deferral in practice, consider this hypothetical example:
- A $50,000 fixed annuity earning 5% annually — tax-deferred — for 10 years compounds to roughly $81,445.
- But the same investment, taxed each year at a 22% marginal rate, only grows to approximately $73,168 after 10 years.
While tax deferral doesn’t eliminate taxes, it can give you more control over when you pay taxes, helping you potentially preserve more of your growth.
The pros of tax-deferred annuities
Tax-deferred annuities can combine tax advantages with guaranteed retirement income and long-term growth, making them central to many retirement plans. Here are some of the main benefits of a deferred annuity.
Tax-deferred growth can boost long-term compounding
Your earnings accumulate without annual income tax. This means your balance can grow faster than it would in taxable investment accounts. Because the IRS doesn’t tax deferred annuity growth until you take withdrawals, you can typically time accessing your money with retirement when your tax bracket might be lower than your working years.
No annual contribution limits for non-qualified annuities
A major advantage of non-qualified tax-deferred annuities is that the IRS doesn’t impose income limits or contribution caps. You can invest as much after-tax money as your income and financial plan allows (or as much as the annuity provider allows). This can help high-income households who already max out 401(k) and IRA accounts.
Guaranteed income options in retirement
The benefits of deferred annuities can go beyond tax benefits. Once you reach retirement age, you can convert your annuity contract into a guaranteed income stream through annuitization or other payout options. Some contracts offer the option for lifetime income or a death benefit to help take care of loved ones after you pass away. Locking in guaranteed income — without concern over stock market risk — can add predictability to your retirement plan.
No required minimum distributions
If you have a non-qualified tax-deferred annuity — one funded with after-tax money — the IRS doesn’t require you to take required minimum distributions (RMDs) at age 73. This benefit helps you coordinate retirement income with other sources, including qualified retirement accounts subject to RMDs. If you have a qualified annuity, one funded with pre-tax money, RMDs are still typically required.
The cons of tax-deferred annuities
Before purchasing a tax-deferred annuity, investors should weigh the advantages with the potential drawbacks.
Withdrawals taxed as ordinary income
In non-qualified deferred annuities, earnings function like ordinary income, so you pay tax when you make withdrawals based on the tax bracket your overall income falls into at that time. For qualified annuities, the entire withdrawal is taxed as ordinary income, not just the earnings portion. This differs from brokerage accounts where long-term capital gains often receive lower tax rates.
Taxation applies to the earnings portion of a non-qualified annuity and every dollar you withdraw from a qualified deferred annuity, which is funded with pre-tax money. Take a large lump sum distribution and you could elevate yourself into a higher tax bracket.
Early withdrawal penalties and surrender charges
Qualified deferred annuities aren’t meant for frequent or early withdrawals. If you take money out prior to turning 59-½, you may face a 10% early withdrawal penalty from the IRS on top of ordinary income tax.
Insurance companies use surrender periods — typically 5 to 10 years — on deferred annuities. Withdrawals above your penalty-free allowance can trigger a surrender charge. Some contracts apply market value adjustments (MVAs) that can decrease your payout if interest rates move against you. Taken together, this means limited liquidity and flexibility, given that you can’t take money out of your deferred annuity as easily and freely as you can with brokerage and savings accounts.
Possible fees on certain products
While many deferred annuities, such as the Gainbridge SteadyPace™ annuity, come with no hidden fees or commissions, other types introduce potentially burdensome costs. For example, with variable annuities, insurance companies often include mortality and expense (M&E) fees, administrative charges, and underlying fund management fees. Additionally, the cost of optional riders can offset annuity earnings.
Are tax-deferred annuities right for you?
Whether or not a tax-deferred annuity is a good investment depends on factors such as your age, tax bracket, financial goals, risk tolerance and liquidity needs. While tax-deferred fixed annuities can work for long-term savers who want predictable income or tax-efficient growth, they’re not suitable for everyone.
Tax-deferred annuities can be ideal for:
- Investors who’ve maxed out 401(k) or IRA contributions: Once you reach the contribution limits for tax-advantaged retirement accounts, a non-qualified tax-deferred annuity lets you enjoy tax deferral without IRS limits. You can invest as much after-tax cash as you’d like up to the stated product contribution limits.
- Savers in higher tax brackets seeking deferred growth: If you think you’ll be in a lower tax bracket in retirement, a deferred annuity can help you move income into your non-working years. This tax deferral strategy can help people better manage their tax liability.
- Retirees who want to avoid market volatility: Fixed annuities provide a locked-in interest rate with no worry about market risk. Deferred income annuities guarantee income you can rely on in retirement with reduced exposure to market swings. Many retirees combine annuity payments with other predictable income sources, such as Social Security and pensions.
Tax-deferred annuities may not be ideal for:
- Those needing frequent withdrawals: Tax-deferred annuities are meant as long-term retirement investments. If you anticipate frequent emergencies or near-term expenses, surrender charges, withdrawal and tax penalties, and limited liquidity become major drawbacks.
- Short-term investors or individuals in low tax brackets: If you have a short investment time horizon, you may not realize the full power of compound growth that tax-deferral can help facilitate. If you’re in a low income tax bracket now, you might benefit less from deferring taxes, particularly if you expect withdrawals later to be taxed at a higher rate.
Using annuities to increase your retirement savings
Tax-deferred fixed annuities can be a key component of your long-term financial plan, helping you put off paying taxes until a later date and providing predictable retirement income. This type of annuity can work well when considered alongside your other investments, time horizon, and liquidity needs.
Gainbridge offers a fixed tax-deferred annuity designed for long-term growth and predictable income, Our platform makes it easy to compare annuities side-by-side so you can choose the option that best fits your retirement strategy.
Explore Gainbridge today to see how our digital-first annuities — with no hidden fees or commissions — can help increase your retirement savings and strengthen your financial future.
This article is intended for informational purposes only. It is not intended to provide, and should not be interpreted as, individualized investment, legal, or tax advice. For advice concerning your own situation please contact the appropriate professional. The GainbridgeⓇ digital platform provides informational and educational resources intended only for self-directed purposes. Gainbridge Life Insurance Company is licensed and authorized to do business in 49 states (all states except New York) and the District of Columbia. Products and/or features may not be available in all states. Guarantees are backed by the financial strength and claims-paying ability of the issuer. Please visit gainbridge.com for current rates, full product disclosure and disclaimers and additional information.
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