Accrued interest is interest that has been earned on a certificate of deposit (CD), bond, annuity or other, interest-bearing investment, but has not been received. This guide focuses on how accrued interest works with deferred annuities.
Key Facts About Annuity Accrued Interest
- Deferred annuity contracts consist of an upfront investment (or series of investments) with an accumulation and distribution period.
- Accrued interest is amassed during an annuity’s accumulation period. It is the interest your annuity has earned but has not yet distributed.
- The interest accrued on an annuity is tax-deferred, meaning you do not have to pay taxes on it until you receive cash distributions.
Accrued Interest vs. Deferred Interest
With respect to deferred annuities, the terms accrued interest and deferred interest are used interchangeably (although they are not always used interchangeably for other financial products). It is important to note that both terms describe interest that has been earned but not yet distributed. Due to this, deferred annuities are sometimes referred to as deferred interest annuities.
In the context of financing arrangements, the term deferred interest is employed with a different meaning. In this context, deferred interest refers to the deferral of an interest obligation for a specified period. Essentially, it means the borrower will not pay any interest on the loan if the entire debt is paid off prior to the end of the deferral period.
For non-qualified annuities, the accrued interest or growth of a deferred annuity is taxed differently depending on how it is distributed. As an annuitized contract, each payment will be representative of the proportion of growth and principal present at the time of annuitization. Principal will not be taxed, while growth will be taxed as income. When taking withdrawals from an unannuitized contract, the principal is left untouched until all growth has been withdrawn, referred to as Last In First Out (LIFO) withdrawals.
Stephen Kates, CFP®Principal Financial Analyst for Annuity.orgStephen Kates, CFP® is a personal finance expert specializing in financial planning and education. He serves as the Principal Financial Analyst for Annuity.org, where he delves into industry trends to support consumers and financial advisors on wealth management, annuities, retirement planning, and investing.
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How Do Interest Earnings Accumulate in a Deferred Annuity?
A deferred annuity contract consists of the following sequence of events:
- An upfront investment (or series of investments)
- An accumulation period that gives your money time to grow
- A distribution period that results in payouts of your interest earnings and principal investment
Interest earnings are amassed during the annuity’s accumulation period. Total growth for earnings depends on the interest rate and crediting method specified in the annuity contract.
The accumulated interest, commonly referred to as accrued interest, is your money. You can begin accessing it at your discretion, following a minimum specified accumulation period. Until then, the interest is permitted to grow on a tax-deferred basis, an advantage that can greatly facilitate your ability to save for retirement.
The higher the average annual interest credit and the longer the accumulation period, the more interest you will accrue with a deferred annuity.
When Does Interest Income Accrue for a Flexible Premium Deferred Annuity?
From a funding perspective, there are two types of deferred annuities, a single premium deferred annuity (SPDA) and a flexible premium deferred annuity (FPDA). As implied, the distinction between the two relates to how they are funded.
An SPDA entails a one-time, lump-sum contribution, while an FPDA allows for periodic contributions, which can vary in amount and frequency. Both vehicles grow on a tax-deferred basis, and both allow the annuitant to determine when to begin receiving penalty-free distributions, following a minimum accumulation period.
Moreover, both these types of annuities accrue interest immediately following a contribution. Because SPDAs are funded upfront with a lump sum payment and FPDAs are usually funded with a series of smaller payments, interest tends to accrue at a faster rate with the former. This is attributable to the power of compound interest, which is the accumulation of interest on your principal investment and previously earned interest.
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Frequently Asked Questions About Annuity Accrued Interest
Accrued interest on a non-qualified annuity — one in which the money you put into it has already been taxed — is not taxed until distributed. When distributions begin, an annuitant will not pay tax on the initial investment. However, all earnings are usually taxable.
Accrued interest is fundamental for interest-bearing financial instruments, such as certificates of deposits, bonds and annuities. It ensures an equitable arrangement between buyers and sellers, recognizing the timing difference between income earned and income paid. It is not problematic unless the interest payor fails to satisfy its financial obligations.
Fundamentally, there are three types of deferred annuities — fixed, indexed and variable. Fixed annuities are the safest of the three, offering a guaranteed rate of interest over a period of time. Indexed annuities are riskier because their returns can fluctuate. Variable annuities are considered the most high-risk as they entail investment positions in volatile financial securities, such as stocks, bonds and money market accounts.
A deferred annuity can make sense for some investors but not everyone. Before buying a fixed, indexed or variable annuity, be sure to thoroughly assess its features and evaluate whether it is a sensible addition to your investment portfolio. A financial advisor can be an invaluable resource during this process. This experienced professional can help you assess your unique circumstances, evaluate your investment options and establish a formal retirement plan.
Writer Lena Borrelli contributed to this article.
