What should you consider before buying a deferred annuity? Deferred annuities are a sound way to build retirement income you cannot outlive. You do not have to worry about lasting longer than the "nest egg" you accumulated for your retirement. Also, including an heir as your beneficiary on your annuity can be a way for your heir to avoid probate and receive a guaranteed death benefit. These benefits of lifetime income and guaranteed death benefit involve additional costs over alternative investments, so you must compare these costs with the benefits of tax savings provided by annuities.

The value of your annuity account grows tax-deferred—there is no need to pay income tax on your increased value during the accumulation period. While contributions to a non-qualified annuity are made from after-tax income, they become your basis in the account; your annuity benefits are taxed according to an exclusion ratio. The exclusion ratio provides that only the portion of your annuitized payments that come from account earnings are subject to taxes. That part of the payments attributable to your after-tax contributions is not taxed again.

In return for these tax benefits, the IRS requires a 10 percent tax penalty on any funds you withdraw before age 59½—the typical penalty for early withdrawals from tax-deferred retirement plans. However, unlike IRAs and other retirement plans, there is no requirement that you begin taking minimum distributions at age 70½. Also, there is no legal limit to the amount you can contribute to your annuity annually, which makes deferred annuities a good option when your annual IRA or 401(k) limits are reached.

If you purchase a deferred annuity, however, be prepared to stay with it for the long haul. Most insurance companies apply a contingent deferred service charge (CDSC) for annual withdrawals made in excess of 10 percent of the account value over an initial period after the annuity's purchase. This is to recover costs of sales and distribution. After this initial period, withdrawal amounts of any size can be made free of a CDSC. A common arrangement is to start with a surrender charge of 7 percent that declines over a seven-year period to 0 percent. Be sure, however, to consult your annuity prospectus (before purchase) and the annuity contract (after purchase) to determine the specifics. Of course, withdrawals before age 59½ are subject to tax penalties, unless you are receiving payments as part of a life annuity payout option. Annuities are primarily for accumulating capital for retirement, not for intermediate investment goals.