For a young couple, annuities tend to be unfamiliar territory as an investment choice, and your first exposure to an annuity could occur while helping someone older make a financial decision. As a retirement savings or planning asset, an annuity may be set up to provide one of several different functions including earning tax-deferred interest. If earned interest also earns interest, an account compounds in value. How compounding works in annuities depends on specific contract features.
Types of Annuities
At the basic level, an annuity is a payment to an insurance company in exchange for a stream of income such as monthly payments. If the payments do not start right away, the contract is referred to as a deferred annuity. If the payments start soon after the purchase — within one year — the contract is an immediate annuity. A deferred annuity can be later annuitized to convert the contract value to a stream of payments. In most cases a deferred annuity can be surrendered for a lump sum value as an alternative to annuitizing the contract.
Deferred Fixed Annuity
A deferred fixed annuity earns interest in a manner similar to a bank certificate of deposit (CD). The insurance company may guarantee an interest rate for several years at a time or reset the rate annually. The interest earned on a fixed annuity compounds, allowing the annuity owner to earn interest on interest as the years roll by. The compounding period is spelled out in the annuity contract, and the compounding period may be quarterly, semi-annually or annually.
Equity Indexed Annuity
Equity indexed deferred annuities earn interest based on the change of a stock market index. How often this type of annuity compounds the interest varies significantly from contract to contract. In the annuity description, the time frame used for the interest calculation — called the index term — determines the compounding period. Index terms can range from one to 10 years. An equity indexed annuity with a long index term can accumulate significant interest due to compounding.
The additional benefit of not paying taxes every year on the interest enhances the compounding of the interest earned. A deferred annuity earns interest that is tax-deferred until the contract is annuitized or a lump sum withdrawal is taken. The interest that would have been paid as taxes stays in the annuity to earn more interest, and adds to the compound growth of the annuity. Deferred annuities are often purchased by someone approaching or even in retirement who does not want to pay taxes on the interest income.
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