How Does Tax Deferral Work to Accumulate More Money?
Tax deferral works because interest added to your account each year is allowed to compound tax-free until you make a withdrawal.
Tax-free compounding takes place whether you are in the accumulation or distribution stage of an annuity, meaning it works for you whether you are have an immediate or a deferred annuity.
Tax is only charged on the overall interest gain on money that is actually paid out from your annuity.
With Deferred Taxation, the government does not take an annual bite from interest in your annuity account.
To see how this may work to your benefit, let’s imagine that you invest a one-off lump-sum of $100 in a fixed annuity and another $100 in a CD account.
(I’d like to think you have more money to invest than this, but $100 is a nice number for this example.)
Let’s also say that both of your investments receive interest at 10% a year and that your tax-rate is 20%. (Two more nice, round numbers – I like to keep the math simple.)
With deferred tax, all of the 10% interest goes into your account every year. If, however, you place the money in a CD account with no tax deferral you effectively earn just 8% a year.
We’ll now fast-forward 25 years and see how much money you have accumulated:
- With tax deferral: Your $100 grows to $1083.47. You pay tax on the final gain, so you pay 20% tax on $983.47. Your final lump sum is therefore $886.78.
- With no tax deferral: Your $100 will grow at 8% compound to $684.85.
The Effect of Tax Deferral on Money Accumulated in a Fixed Annuity at a 20% Tax Rate
You will sometimes hear this tax advantage described as triple compounding: every year, an annuity account earns interest on:
- The payments you make into your account
- The interest paid in previous years
- The money you would have paid to the taxman but for the fact that your money is in a tax deferred account
IRAs and employer-sponsored 401(k) plans also come with tax deferral. For most people, saving money into deferred annuities should be used to supplement rather than replace IRAs and employer-sponsored 401(k) plans. Deferred annuities can be good for you if:
- You pay a high tax rate now. You can avoid some of that tax if you save into a deferred annuity and then withdraw the money in instalments when your tax rate is lower – typically in retirement.
- You have maxed out on you employers’ salary reduction plan but still want to save more for retirement.
- You have unusually large incomes some years and lower incomes in other years. You could find deferred annuities useful, because unlike IRAs and employer sponsored plans, there are no federal limits on contributions to deferred annuities.
A further benefit of tax deferral for wealthier investors is that when you receive income from your annuity, any gains are taxed as ordinary income at your current income tax rate. There is no capital gains tax. If your income tax rate is lower when you receive payments than while you are saving, as may be the case after you retire, this also works to your financial benefit.
Variable Deferred Annuities May Perform More Poorly For You Than Mutual Funds Would
Deciding whether to invest money in a deferred variable annuity or straight into mutual funds requires rather careful consideration of your own current and predicted future circumstances from a tax perspective. For example, if you currently pay income tax at a high rate, and you expect to still pay income tax at a high rate when you take a lump sum from your annuity, it’s possible that investing your money straight into mutual funds could build you a larger lump sum. This is because the ordinary income tax charged at the end of the annuity period might be more than the capital and dividend taxes charged (at a lower rate) each year when you invest straight into mutual funds. You need to weigh up your current and expected future financial position to decide whether a deferred variable annuity is likely to accumulate a larger lump sum for you than the same mutual funds would outside the annuity.