The Hypothesis. Financial professionals selling annuities promote the benefits of tax-deferred investment growth with guaranteed returns. I recently came across an article touting how a tax-deferred annuity grows to a bigger balance than an investment in a taxable account. While the accompanying chart showing the superiority of the annuity looked impressive, it was missing one very important aspect. It only showed the tax consequences during the accumulation phase. What happens to the value of your investment when you withdraw it and use it for your ultimate purpose?
The Basics. Let’s start with a basic understanding about annuities and taxes. A deferred annuity is a tax-deferred investment vehicle that comes with an insurance contract that typically guarantees a return and/or death benefit. Contributions to an annuity are not subject to annual contribution limits and they do not reduce your taxable income. However, the earnings inside the annuity grow tax-deferred. Earnings from withdrawals made after age 59 ½ are taxed as ordinary income and earnings from earlier withdrawals are assessed an additional 10% penalty.
A taxable account is taxed according to the properties of the underlying security. Interest income and ordinary dividends are taxed at ordinary income tax rates. However, capital gains on equities held for longer than one year and qualified dividends are taxed at the 15% preferential capital gains rate for taxpayers in a marginal tax rate of 25% or higher. For taxpayers in a marginal tax rate lower than 15%, there is no tax on long-term capital gains and qualified dividends.
The Reality. The following hypothetical illustration compares the balance of three investment options during accumulation and after withdrawal. The annuity accumulates faster than the taxable accounts because it is not reduced for taxes during the accumulation phase. But, because the tax rate on the withdrawal of the annuity is so much higher, it does not necessarily yield a better economic benefit.
Even my illustration is oversimplified. For example, it excludes the additional fees associated with annuity contracts that are typically not found with standard accounts. In most cases, these fees offset any incremental advantages of annuities compared to products like certificates of deposit. Furthermore, each investor has their own unique tax situation and investing goals that simply cannot be generalized. For example, an investor in the 15% marginal tax bracket would actually incur a negative tax impact with an annuity.
Purchasing an annuity requires careful consideration that takes into account your specific situation. Contact our office to learn more about tax-advantaged investing.