If you want retirement income beyond what you will receive from Social Security or your pension plan, a deferred annuity may be what you’re looking for. They are particularly effective if you have many years until retirement. Your money has the potential to grow, tax-deferred. That means you pay no income taxes on investment earnings until you begin to withdraw your money.1
If the tax-deferred aspect of a deferred annuity is important to you, make sure the expenses do not outweigh the tax benefits. This can be a tough judgment. Consult a professional financial advisor for assistance in making this determination.
A nonqualified deferred annuity is not a vehicle for money you may need for current expenses. If you withdraw income before age
59 1⁄2, the IRS will usually apply a 10 percent tax penalty in addition to ordinary income tax, similar to the federal income tax penalty for early IRA withdrawals. What’s more, your insurer may impose its own early withdrawal penalty, also known as surrender fees, if you cash in all or part of your deferred annuity within a specified period. These fees, similar to withdrawal penalties on a CD, often cease seven years after your date of purchase. There is often a separate surrender fee for each payment. A new payment may have a 7 percent fee if you take out the new payment right away, while a 10-year-old payment may have no surrender fee. The fee will usually decrease and be eliminated over time. Keep in mind, however, you can often withdraw small amounts (e.g., 10 percent) annually without any penalty from your insurer, but the federal tax penalty may still apply. In general, all taxable withdrawals are ordinary income, until all income has been paid out. Again, the prospectus for the annuity you purchase will have all of the specific details pertaining to that particular annuity.
If you switch annuities, you may also incur withdrawal charges from your current annuity. If a salesperson advises you to change annuities despite the fact that you will be penalized, make sure you know the reason. Do the benefits of the new annuity — such as a higher interest rate, better investment choices or greater flexibility — offset the withdrawal charges? Be sure the salesperson isn’t benefiting from the switch at your expense. How do the fees and charges of your existing contract compare with the proposed new contract? If you decide to exchange one annuity for another, you usually should request and complete the appropriate forms provided by your insurance company to enable the transaction to be treated as a tax-free exchange under the federal income tax law (section 1035 of the Internal Revenue Code).
Withdrawing Money From a Deferred 
Annuity. When you’re ready to start withdrawing money from your deferred annuity, you will need to choose how to receive your money. You can take it all out in a lump sum, take it as needed, or receive it in a steady stream of periodic payments — so-called “annuitizing.” If you annuitize, you can receive a stream of income that is guaranteed to continue for the rest of your life, no matter how long you live. And the tax liability can be spread out for the rest of your life, too. Some of the earnings are included in each payment and are taxable; meanwhile, tax-deferred earnings can continue to accumulate on the remaining contributions and earnings that have not yet been distributed. Choosing the alternative of receiving distributions as periodic payments after retirement may further reduce your income tax liability, if you are in a lower income tax bracket in later years. Some annuities also provide you with an option called systematic withdrawal to have a set amount, determined by you, automatically withdrawn and deposited directly in your bank account at regularly scheduled intervals, such as monthly. You have many options for receiving your money, each with its own tax ramifications. Consult your tax professional or financial advisor to tailor a plan for your particular needs.
1 Tax laws and regulations are subject to change. Unlike a nonqualified deferred annuity purchased with after-tax-dollars, an IRA receives tax deferral under the non-annuity provisions of the Internal Revenue Code. Therefore, there is no additional tax benefit to purchasing a deferred annuity to fund an IRA.
