Deferred Annuities

Deferred annuities can be a great way to accumulate money for retirement, if you want retirement income beyond what you will receive from Social Security or your pension plan. They are particularly effective if you have many years before retirement. Your money grows tax deferred, which means you pay no taxes on earnings until you begin to withdraw your money.

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 call, but a good guideline is that if the expense charges are more than 1.5% greater than a comparable financial vehicle and your time horizon is less than 10 years, a deferred annuity may not be the option for you. Consult a tax advisor for assistance in making this determination.

A 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% penalty in addition to ordinary income tax, similar to the penalty for early IRA withdrawals. What's more, your insurer may impose its own early withdrawal penalty, known as surrender fees, if you cash in your deferred annuity (surrender it) within a specified period. These fees, similar to withdrawal penalties on a CD, usually cease seven years after your date of purchase. Often there is a separate surrender fee for each payment.

So, a new payment may have a 7% fee if you take the new payment out 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%) annually without any penalty from your insurer, but the IRS penalty may still apply. The IRS views all withdrawals as income, which are taxable, until all income has been paid out.

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.

If you decide to exchange one annuity for another, be sure to request and complete the appropriate forms provided by your insurance company to ensure that the transaction will 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, any earnings continue to accumulate tax-deferred on the remaining principal and earnings that have not yet been distributed. So, receiving distributions as periodic payments after retirement may further reduce your income tax liability, if you are in a lower tax bracket. Some annuities also provide you with an option to have a set amount, determined by you, automatically withdrawn and deposited directly in your checking account during a regularly scheduled period, such as monthly.

You have many options on how you receive your money, each with its own tax ramifications. Consult your tax or financial advisor to tailor a plan for your particular needs.

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