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A single premium deferred annuity (SPDA) is purchased with one upfront payment, allowing the funds to grow tax-deferred until distributions begin at a future date you select. Unlike immediate annuities, which start paying out within a year, an SPDA delays income, often until retirement. This structure makes it useful for someone with a lump sum such as an inheritance or retirement account rollover who wants to convert that money into a predictable income stream later on. The longer the deferral period, the more time the account has to accumulate interest before payouts begin.
Consider working with a financial advisor as you evaluate specific annuity options.
What Is a Single Premium Deferred Annuity?
To understand how a single premium deferred annuity works, it helps to start with how annuities are funded. Some annuities allow you to make payments over time, while others require one lump sum when the contract is purchased.
SPDAs fall into the latter category. You make one upfront payment, often from a windfall or a rollover from a former employer’s 401(k). After that initial contribution, no further premium payments are required.
Contracts typically set a minimum premium, such as $5,000, and some may also impose a maximum, which could be $500,000 or $1 million. These limits vary by provider and contract terms.
The “deferred” feature refers to when payouts begin. For instance, you might purchase an annuity at age 50 but delay income until you retire at 65. During this waiting period, the funds grow on a tax-deferred basis. This contrasts with immediate annuities, which generally start issuing payments within the first year after purchase.
Benefits of SPDAs
These annuities have several attractive features for investors who have lots of time. First, SPDAs can offer a guaranteed rate of return. That means you can predict how much your policy may grow. This can make planning retirement easier if you have other sources of income, such as Social Security benefits or a 401(k) or individual retirement account.
Next, SPDAs may offer guaranteed principal protection, meaning you’ll always be able to get back at least what you put into the contract. For example, say you received a $500,000 inheritance and used that to purchase one of these annuities. As a result, you’ll receive that amount back once the annuity payments begin.
Assuming your annuity grows in value, the interest earned is tax-deferred. That means you wouldn’t owe taxes on it until you begin taking distributions from the annuity. With a qualified annuity, which is funded through a tax-advantaged plan such as a 401(k), both the amounts you pay in and the interest earned are taxable. A nonqualified IRA, which is funded with after-tax dollars, would only be taxable as far as interest gains are concerned.
Potential Drawbacks of SPDAs
There are a few things to keep in mind if you’re considering a SPDA. The first thing to assess is whether you might want a fixed or variable annuity contract.
With a fixed annuity, the rate of return is generally guaranteed. With a variable annuity, it’s not. Variable annuities can offer the potential for greater returns if the underlying investments in the annuity perform well. However, you’re usually taking on a higher degree of risk to try to achieve those returns. For that reason, a fixed single premium deferred annuity might be preferable if you’re looking for a lower-risk option.
Also, you may pay a surrender charge if you need or decide to cash out the annuity early. A surrender charge is a fee you pay to the insurance company to end your contract. The amount of the charge is often determined every year and decreases the longer you own the annuity. Within the first five years, for example, the surrender charge might be 7% to 10% each year. But after year five, it may decrease by a percentage point each year until the fee reaches zero.
Finally, keep in mind that an annuity is an insurance policy, not an investment in a tradable security like a stock, commodity or mutual or exchange-traded fund (ETF). Such securities often provide capital appreciation that, by definition, is not possible in an insurance policy.
How to Choose a SPDA
If you think this type of annuity might be right for you, there are a few things to keep in mind. First, consider when you’ll need to begin receiving income from the annuity. A SPDA tends to be more beneficial when you have a longer window for the accumulation phase when your money is growing. If you need to start receiving monthly income payments right away, an immediate annuity might be preferable.
Next, think about how much you can realistically afford to spend on the upfront premium. If you don’t have $5,000, $50,000 or $500,000, for example, you might want to look at something like a flexible premium annuity instead. With this type of annuity, you can make one small initial premium payment and then continue paying premiums over time.
Finally, take a look at the terms of the annuity contract itself, including fees and any available riders. See if there’s a free look period. It lets you cancel the annuity contract without a penalty within a certain time frame. It’s also good to assess the surrender charge and other annuity fees you might pay. Include any expenses associated with the underlying investments so you know what the annuity will cost over time.
Tax Considerations of SPDAs
In addition to the above considerations, it’s also important to get an idea of how a single premium deferred annuity could affect your taxes. As we mentioned above, one of the main benefits is their tax-deferred nature, meaning you won’t pay taxes on the growth of your investment until you withdraw the funds. However, when you do begin making withdrawals, the earnings are taxed as ordinary income, not capital gains, which may result in a higher tax rate depending on your income bracket.
Additionally, if you withdraw funds before age 59 ½, you may face a 10% early withdrawal penalty from the IRS, in addition to the regular income tax on the earnings.
Annuities are often funded with after-tax dollars, which means only the earnings portion of withdrawals is taxable while the original premium is not. However, if the annuity is held inside a tax-advantaged account like an IRA, then both contributions and earnings are fully taxable at withdrawal.
For estate planning, beneficiaries who inherit a SPDA must pay income tax on the taxable portion of distributions, typically under rules that require withdrawals within a set period of time. It’s a good idea to consult with a financial advisor to understand your specific situation.
Bottom Line
A single premium deferred annuity offers a way to turn a lump sum into future income while allowing earnings to grow tax-deferred. It can complement other retirement assets, providing predictable payouts later in life. Keep in mind that taxes will apply to the earnings once withdrawals begin, so factoring those obligations into your overall retirement plan is key.
Retirement Planning Tips
- Consider talking to a financial advisor about single premium deferred annuities or annuities in general. An advisor can explain the benefits and potential drawbacks of using an annuity as you plan for retirement. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
- Compare the projected returns you may get with a single premium deferred annuity to the return you could get by investing the money you’d use to pay the premiums elsewhere. Consider the liquidity factor as well. You might be able to get the same or a similar rate of return using a certificate of deposit, for example, and it may be easier and less expensive to terminate a CD early compared to getting out of an annuity.
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