A tax-deferred annuity lets you postpone tax on any earnings as they accumulate and pay tax at your regular rate on withdrawals. However, since you buy the annuity with after-tax dollars, the portion of your withdrawal that comes from your premiums isn’t taxed. Like IRAs, there’s an early withdrawal penalty if you take money out before you reach 59 1/2—though there may be a provision in your contract allowing you to take a small percentage each year penalty free.
Unlike IRAs, however, you can contribute money from any source to a nonqualified annuity, including investment income or an inheritance. You can put in any amount you can afford, usually up to $1 million per contract—though few people approach that limit.
You can choose a fixed annuity, which means that the insurance company offering the contract guarantees the earnings at a specific rate, subject to the company’s ability to meet its obligations. Or, if you prefer, you can choose a variable annuity. In this case, your earnings from the annuity depend on the investment performance of the underlying securities held in the investment funds (also called subaccounts) that you select from among those offered in your contract. As the term “variable” implies, the rate at which you accumulate earnings will depend the performance of the underlying investments.
One drawback to tax-deferred annuities, and variable annuities in particular, is that the annual fees for these products may be higher than those for an IRA invested in mutual funds or individual investments, such as stocks and bonds.