Deferred annuities, fixed and variable, get their name because they offer tax deferral but they have some negative tax aspects, too.

  • Taxable withdrawals. Not only will you owe tax on money you pull out, in most cases, there’s also a 10 percent tax penalty for withdrawals before age 59 1/2. In addition, insurers may impose surrender charges for withdrawals in the first few years.

  • Loss of capital gains treatment. Under current law, all withdrawn earnings from deferred annuities are taxed as ordinary income. If you invest in stock funds within a variable annuity, and enjoy gains, you won’t get favorable tax rates when you take out those profits.

  • Double taxation at death. With a deferred annuity, the deferred income tax must be paid by someone, either you or your beneficiary. The account also will be included in your estate, for tax purposes.

Therefore, you need to hold onto a deferred annuity for many years, in order for the value of the tax deferral to outweigh the loss of long-term capital gains rates. Moreover, you shouldn’t plan to hold onto a deferred annuity until death if you expect to leave an estate large enough to be subject to estate tax.