How Do Tax Deferred Annuities Work? 
There are two basic classifications of annuities , immediate and deferred . The immediate annuity provides income payments over the lifetime of the annuitant starting within one year of the deposit . The deferred annuity doesnt start payments until a later date . Deferred annuities may increase in value over time . That increase is not subject to income tax as it occurs . This deferral of taxation is a major attraction of annuities . A deferred annuity can be either a single premium annuity or a flexible annuity . As a single premium annuity it is often used to augment retirement income at a later date , when other streams of income may have ceased . It is often used to anticipate increases in inflation , providing a much needed boost in income . As a flexible deferred annuity the contract allows the owner to make deposits on either a scheduled or unscheduled basis into the policy . As mentioned previously earnings on the contract are not taxed in the years that the money is accumulating . A deferred annuity can be classified into three major groups . The first would be the fixed annuity , the second would be the variable annuity and the third would be the indexed annuity . The fixed annuity is issued by an insurance company . The owner makes at least one deposit and everything that takes place later is the responsibility of the insurance company . The company guarantees the growth and guarantees the future payments . There isnt any market risk in this policy . A variable annuity , while structured similarly by the insurance company that issues it , allows that the owner can select the funds that will accumulate to provide future benefits . In some cases it may extend the privilege of selecting underlying funds into the annuitization phase which will result in uneven results but has the potential of exceptional growth . An index annuity lies somewhere in between . The index annuity is designed by the insurance company but rather than paying a guaranteed rate of interest , bases interest payments on the performance of one of the leading market indicators . Commonly these policies are linked to the Dow Jones Average or the Standard and Poors index . The annuity has restrictions on the amount of interest credited . The interest rate can either be capped at a preset percentage or the policy can be written so that only a percentage of the rate is applied to the money in the annuity . The trade-off comes when the company guarantees a minimum rate of interest . That minimum rate is often 0 % . What this means is that the annuity can participate somewhat in the increases experienced in the stock market without the risk of losing anything . This is quite attractive and currently very popular . An aspect of all annuities that is often overlooked is that they are not subject to probate . That means that as a contract the value of the annuity passes to a designated beneficiary without the expensive and time consuming process known as probate . Taxation of annuities is another subject but it is important to know where the annuity is going to be held to determine its taxation . 