Tax deferral with annuities is one of the key benefits offered by annuity contracts, allowing investors to grow their investments without immediately paying taxes on the earnings. This can be a powerful tool for long-term financial planning, especially for retirement. The concept of tax deferral helps investors accumulate wealth faster because the interest, dividends, or capital gains generated by the annuity are not taxed until the funds are withdrawn, typically at retirement.
Tax deferral refers to the postponement of tax payments on the earnings or gains of an investment until a later date, often when the funds are withdrawn. In the case of annuities, this means that the interest, dividends, and capital gains generated within the annuity contract are not taxed annually. Instead, they are deferred until the investor begins to take withdrawals from the annuity, usually during retirement. This arrangement allows the investment to grow without the drag of annual taxes, significantly boosting the potential for long-term growth. The funds compound and grow more efficiently over time since the earnings are not diminished by yearly taxes.
Tax deferral works by allowing the money inside the annuity to grow without being taxed during the accumulation phase, which is the period before withdrawals begin. During this phase, investors are not required to pay taxes on the earnings from their investment. When they eventually begin to withdraw money from the annuity, usually during retirement, the withdrawals are taxed as ordinary income rather than at the capital gains rate or any other preferential rate. The amount of tax paid depends on total income and the tax rates in place at the time of withdrawal.
Several types of annuities provide tax deferral, each with its own unique characteristics. Fixed annuities offer a guaranteed interest rate for a set period of time, providing a predictable stream of income. The growth of the investment is tax-deferred, meaning no taxes are paid on the interest earned each year. When withdrawals begin, the earnings are taxed as ordinary income. Variable annuities are more flexible than fixed annuities, offering a wide range of investment options, including stocks, bonds, and mutual funds. The returns on variable annuities fluctuate based on the performance of the chosen investments, but like fixed annuities, the earnings within the annuity grow tax-deferred, and withdrawals are taxed as ordinary income.
Immediate annuities provide a stream of income that starts immediately after purchase. While the principal portion of the payments is not taxed, the earnings are tax-deferred and are taxed as ordinary income when received. Indexed annuities are tied to a stock market index, such as the S&P 500, offering the potential for higher returns than fixed annuities while providing a level of protection from market downturns. The earnings from indexed annuities are also tax-deferred until funds are withdrawn.
The benefits of tax deferral with annuities are substantial. By deferring taxes on the investment earnings, money is allowed to compound more effectively, leading to faster growth. Without taxes reducing returns each year, the investment has more opportunity to grow over time, which is particularly beneficial for long-term goals like retirement. Having tax-deferred annuities in a portfolio can provide tax diversification, which is useful during retirement. When withdrawing from tax-deferred accounts, ordinary income tax is owed, but the flexibility of having multiple sources of income can help manage tax exposure in retirement. Additionally, many individuals retire in a lower tax bracket than during their working years, making tax deferral particularly advantageous. Some annuities offer a guaranteed income stream for life, securing predictable income in retirement. Tax deferral allows this guaranteed income to grow over time, potentially providing a larger income later in life.
However, tax deferral with annuities also comes with potential drawbacks. While it allows for greater growth, the downside is that funds will be taxed as ordinary income when withdrawn. For high-income retirees, this can result in a significant tax bill. Unlike tax-advantaged accounts such as Roth IRAs, where withdrawals can be tax-free, annuities do not offer the same level of tax advantage upon withdrawal. Annuities often come with surrender charges if funds are withdrawn early, typically within the first few years of purchasing the annuity. These charges can eat into the investment and reduce the benefit of tax deferral if funds need to be accessed sooner than expected. Additionally, annuities can come with high fees, especially for variable and indexed annuities. These fees may reduce the overall growth of the investment, and combined with taxes upon withdrawal, the net return may not be as high as anticipated. Like other tax-deferred retirement accounts, annuities are subject to required minimum distributions (RMDs) once the investor reaches age 73 (as of 2023). This means that withdrawals must begin at a certain age, which could result in higher taxable income in retirement.
Tax deferral with annuities is an appealing feature for long-term investors, offering the opportunity to grow investments without paying annual taxes on earnings. Whether looking to create a predictable income stream in retirement, reduce the current tax burden, or ensure tax-efficient growth, annuities with tax deferral can be an effective tool in financial planning. However, it is important to weigh the benefits against the potential drawbacks, including taxes upon withdrawal and fees associated with annuities. Consulting with a financial advisor can help determine if tax-deferral annuities are the right choice for an individual’s investment strategy and retirement planning.
The commentary on this blog reflects the personal opinions, viewpoints and analyses of the author, Katherine Sullivan, and should not be regarded as a description of advisory services provided by Foundations Investment Advisors, LLC (“Foundations”), or performance returns of any Foundations client. The views reflected in the commentary are subject to change at any time without notice. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security, or any security. Foundations manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary.
Investment advisory services offered through Foundations Investment Advisors, LLC (“Foundations”), an SEC registered investment adviser. The views, statements and opinions expressed herein are those of the author, and not necessarily of Foundations or their affiliates. The content provided is for educational purposes only and the views reflected are subject to change at any time without notice. No investment, legal or tax advice is provided. Always consult with a professional. Foundations deems reliable any statistical data or information obtained from third party sources that is included in this article, but in no way guarantees its accuracy or completeness. Rates and guarantees provided by insurance products and annuities are subject to the financial strength of the issuing insurance company; not guaranteed by any bank or the FDIC.
