Contribution Limits of a Tax-Deferred Annuity

When you purchase a tax-deferred annuity, you purchase a life insurance product that insures your income instead of providing explicit benefits for beneficiaries. These insurance policies are designed to convert to guaranteed payments during retirement, but may be held as a savings indefinitely. They're treated as retirement accounts by the Internal Revenue Service in most respects except one: There are no contribution limits on a tax-deferred annuity.

Types

There are two basic types of tax-deferred annuities. A fixed annuity guarantees the annuity principal and interest in the contract. A variable annuity offers no guarantee of accumulation but offers higher potential earnings through non-guaranteed investments such as mutual funds. In addition, an indexed annuity provides for a contract that is a blend of a traditional fixed annuity and a variable annuity. Contract values are guaranteed against loss. Investment gains are tied to only the upward movement of a stock market index. But, earnings are capped and no dividends are paid (as they would be with an ordinary investment in mutual funds).

Benefit

The benefit of a tax-deferred annuity is that you earn compound interest on the taxes you otherwise would have had to pay. Your savings grows to a larger balance than would otherwise happen due to this fact. You may make withdrawals from the annuity, usually up to 10 or 20 percent of the total annuity value (although this depends entirely on the insurance company's policy on withdrawals) for any reason before you retire. Finally, there are no contribution limits. Because of this, you may accumulate as much money as you want inside the annuity through contributions.

Disadvantage

The disadvantage to annuities is that the contributions, while unlimited, are not tax deductible. Although money accumulates tax-free inside of the account, money withdrawn from the policy is subject to income tax. If you make ordinary withdrawals from the annuity, then all of the interest must be removed prior to the investment principal. If you convert the annuity to a savings then most of the payment consists of a return of principal with a small amount of interest added to it, thus lowering your potential tax burden. But, in either case, you must pay taxes on your distribution.

Consideration

When considering whether or not to purchase a tax-deferred annuity, consider contributing to retirement plans like a 401k plan or IRA first. When you've contributed the maximum dollar amount to those plans, an annuity may allow you to add additional retirement savings with some, but not all, of the tax benefits of your 401k or IRA.

References

  • "Life & Health Insurance, License Exam Manual, 6th Edition"; Dearborn Financial; 2004
  • "Practicing Financial Planning for Professionals (Practitioners' Edition), 10th Edition"; Sid Mittra, Anandi P. Sahu, Robert A Crane; 2007

About the Author

I am a Registered Financial Consultant with 6 years experience in the financial services industry. I am trained in the financial planning process, with an emphasis in life insurance and annuity contracts. I have written for Demand Studios since 2009.