FastFacts: Deferred Annuities

How they work: In general, you make a contract with an insurance company in which you agree to the following: You'll make a lump-sum payment, or a series of payments over a number of years, to the insurance company. The insurance company will invest your payments on your behalf and your money grows on a tax-deferred basis. When retirement rolls around, you get your money back, either in a lump sum, through partial withdrawals, or in the form of a guaranteed income for a specified period or your lifetime.

As with other retirement investments, deferred annuities are designed to be held for the long-term so you have to hang on for the long haul so the benefit of tax deferral has time to offset an annuity's annual costs. Most insurers levy surrender penalties for early withdrawals. Plus, if you withdraw money before age 59½, you'll generally be hit with a 10% tax penalty in addition to the ordinary income tax due on your account's earnings. Moreover, an annuity's earnings are taxed differently than some other types of investments, so be sure to get all the details before investing.

Risk: Since annuities are not government insured and are not products of financial institutions, the strength of an insurance company is what stands behind its guarantees, so be sure to check out a company's financial ratings.

Fixed annuities: There are two main types of deferred annuities: Fixed annuities guarantee your principal and a stated interest rate for a specified period of time. After that, the rate is reset periodically to reflect changes in market interest rates, although there's usually a minimum guaranteed rate.

Variable annuities: are designed to keep pace with the cost of living, allowing you to choose where you want your money invested from a selection of money-market, stock, or bond subaccounts. Unlike a fixed annuity, your principal isn't guaranteed, nor are specified returns. Instead, your return is based upon the performance of the underlying investments you select.

Variable annuities have a death benefit feature that guarantees that if you die before your account has started paying out, your beneficiary will receive either the value of your account at the time, or at least the amount you invested, less any withdrawals you've made.