Tax Advantages of Annuities Explained

Annuities have long been the investment of choice for people seeking safe, stable returns and a guaranteed stream of income for life. Their popularity exploded, though, once the Internal Revenue Code established their favorable tax treatment. Since then, the popularity of annuities has correlated with the rise and fall of the tax rates. Their popularity reached its zenith in the 1980’s when top tax bracket was 70% and interest rates had climbed to astronomical heights. The notion that one could earn double digit returns, without risk while not paying taxes on them held mass appeal for many investors whose income tax rates exceeded 50%. It was like earning an instant 50% return on their investment. It was hard to do better than that.

The Advantage of Tax Deferral

Since then, tax rates and interest rates have fallen significantly. But, the tax advantages of annuities are still attractive enough for investors who want to maximize their returns by minimizing their taxes. The top federal tax rate today is 35%, but when you add in state taxes, investors can still be subject to a combined tax rate as high as 47%. That means for every dollar they earn, they currently save 47 cents in taxes. Annuity earnings are eventually taxed as ordinary income when they are withdrawn, so the tax savings are only temporary. But, what tax deferral does for investment earnings is it lets them accumulate unencumbered by taxes enabling them to compound much faster than if the taxes were paid on them when they are earned. When the “miracle of compounding interest” is combined with tax deferral, the long term results can be overwhelming.

Take for example a hypothetical $10,000 investment that returns a steady 6% return. For someone in a combined tax bracket of 40% the total growth of the account would amount to $40,817 over 30 years. In a tax deferred account, it would grow to $57,435.

Tax Flexibility

Eventually taxes on annuity earnings have to be paid. But, at least you can control when and how that happens. For many people, the first withdrawals they take would occur in retirement. The expectation of most people is that they will be in a lower tax bracket in retirement. If they were in the higher brackets during their peak earning years, they could see their tax rate drop significantly depending on the amount of income and its source. If they have multiple sources of income, they can choose when to take withdrawals from their annuity based on their tax situation at a given time. If they have other sources of income, they could allow their annuity earnings to accumulate and defer taxed further into the future.

Making Tax Deferral Last

For retirees interested in getting the maximum income from their annuities while deferring taxes as far as they can go, they could convert their deferred annuity into an immediate annuity. A key tax advantage of immediate annuities explained is the return of principal component of the income payment. Essentially, when a lump sum of capital is converted into an income annuity, the payments from the life insurance company consist of both a return of principal and interest earned on the principal. So, taxes will only be owed on the interest portion. The income payments are calculated based on a total depletion of the principal and interest earned over the specified payment periods, or, in the case of a lifetime annuity for the life of the annuitant. So, for a good portion of the annuity earnings, taxes can be deferred for many years.

Summary

For a non-qualified investment, annuities have a unique tax advantage with their tax deferral. Contributions to annuities are made with after-tax dollars, as opposed to pre-tax dollars for qualified retirement accounts. However, there is no limit to the amount of contributions made to annuities as there are with qualified plans. For people with the capacity to save for retirement beyond their qualified plan contributions, an annuity is the next best thing for achieving tax favored growth of earning. And, with the availability of growth oriented annuities, such as variable or indexed annuities, investors who seek the greatest amount of diversification and growth opportunities, can realize higher tax favored returns.

It is always advisable to seek the guidance of a qualified tax professional when considering the tax aspect of annuities. And, for optimum planning for retirement or for the disposition of your estate, it is recommended that you seek the counsel of qualified financial advisors for the best understanding of how annuities will work in your particular situation.