Tax Advantages of Annuities

Tax advantages of annuities:

Understanding the potential benefits for you and your family

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Give your retirement savings a boost

We all know that being physically healthy is important, for ourselves and for our families. Good physical health helps us make the most out of life today and lays the foundation for staying healthy as we get older. The same applies to financial health: we can do things to make ourselves financially strong now and have a financially healthy future. Planning ahead for a financially secure retirement allows us to enjoy life more today, since it makes us less worried about how we will generate enough income to achieve our retirement goals (which can include traveling, pursuing hobbies, volunteering and spoiling future grandchildren a bit).

Simply put, saving early and investing wisely today can help you prepare for a financially healthy retirement. Most of us probably focus more on the "invest wisely" part of that statement as the way to prepare for retirement, but we shouldn't overlook the "save" part. There are various ways to save more by reducing current spending, but there is one strategy to save more for retirement that may not be so obvious: postponing ("deferring") income taxes owed on interest earned on our investments. Doing so allows you to continue investing the money you would have used to pay those taxes, so all your money can potentially keep working hard for you.

Investing more without spending less

Of course, keeping a portion of your assets in a taxable investment account could be a good idea because even though you do have to pay taxes on those investment returns every year, you can withdraw your money at any time. Also, you can invest that money in virtually anything you like--from individual stocks to niche ETF and mutual fund products that can specialize in just about any corner of the investment world. But it is important to understand why tax-deferred investing can be a powerful way to invest more for the future without reducing current spending.

Keeping 100% of your investment earnings instead of giving a sizable portion of those earnings to the IRS each year probably sounds appealing. After all, most of us don't like paying taxes. But there is more to deferring taxes than just avoiding something unpleasant; doing so can be a big boost to your ability to achieve the outcomes you want for retirement. By postponing tax payments for each year between now and retirement, more of your money stays invested for a longer period. Every dollar that stays invested year after year has the potential to earn more for you and your family, and takes you another step toward a comfortable retirement.

You may already be taking advantage of tax-deferred investing by putting money into a 401(k) plan at work or into a traditional IRA. Both of these savings vehicles allow you to postpone paying taxes on the interest, dividends and any increase in value (capital gains) the account accumulates, until you start taking withdrawals in retirement. These can be great ways to defer taxes because all the money you put into those accounts can work for you for many years before you retire.

However, there are limits on how much you can put into a 401(k) or an IRA each year. While those limits may not seem restrictive to someone who is just starting out in the workforce, as you move through your 30s, 40s and 50s and your income increases, you may find that you actually could invest more than these tax-deferred plans allow.

But how can you legally postpone paying taxes on more of your investment earnings after you have maxed out your 401(k) or IRA contributions? Annuities can be a great way to do just that. Annuities are long-term, tax-deferred products designed for retirement. Just like other types of investments, annuities offer a wide variety of

What is an Annuity? Annuities are long-term, tax-deferred vehicles designed for retirement. Variable annuities involve investment risks and may lose value. Earnings are taxable as ordinary income when distributed and may be subject to a 10% additional tax if withdrawn before age 59?.

Investing involves risk, including possible loss of principal. Tax deferral offers no additional value if an annuity is used to fund a qualified plan, such as a 401(k) or IRA. It also may not be available if the annuity is owned by a "non-natural person" such as a corporation or certain types of trusts.

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investment choices that can range from more conservative, with no exposure to the ups and downs of the stock market, to more aggressive, offering a chance to participate in the stock market's growth, with other options in between. No matter which type you choose, annuities offer the advantage of letting you defer taxes on your earnings, and that can translate into a benefit for many people.

Taxable versus tax-deferred returns

Here's a simple example using a conservative strategy to illustrate the value of tax deferral: Imagine you have $100,000 available to invest today. You do some research and learn that you can put your money into a taxable investment that pays 3% interest every year, or into a tax-deferred account that also provides a return of 3% per year. With the taxable investment, you would pay federal, and perhaps state, income taxes on the 3% return every year. With the tax-deferred account, you pay no taxes until after you choose to start withdrawing money from the account, sometime after you turn 59? years of age (or perhaps much later).

Let's assume you are in the 22% tax bracket for federal taxes and a 3% bracket in your state, for a total tax bracket of 25%. With the taxable-investment approach, you would keep only 75% of the interest you earn each year, since 25% would be paid out in taxes. In the first year, your $100,000 investment would earn a return of $3,000. Of that, you would pay $750 in taxes and reinvest the remaining $2,250 in the account, so in the second year, the account would start off with $102,250. Year after year, the amount in the

account would increase, but not by the full 3% per year, because some of your return would be used to pay those taxes (25% of your investment earnings) every year.

As noted above, with a tax-deferred account you pay no taxes until you start to receive payouts, typically after you retire. Therefore, 100% of the investment return you earn each year is reinvested, and that investment income itself earns a return, which keeps the full power of compounded interest working for you. Tax deferral and the resulting increase in compound interest may make the total amount in the tax-deferred account grow faster than the total you would have accumulated in the taxable investment.

Continuing with our example, the $100,000 in the tax-deferred savings account would also earn $3,000 in year one, but the amount available to invest in year two would be $103,000, compared to the $102,250 available for reinvestment in the taxable account. That additional $750 might not sound like a huge amount, but it really can add up over time. This chart shows how the difference between the two approaches could grow over the years, based on a 25% tax rate:

Variable annuities and the importance of asset location

As noted earlier, many annuities offer exposure to the stock market through a wide range of investment choices. Since they are taxdeferred, these variable annuities allow you to keep the potential returns earned on these investments without paying taxes on them every year. It is important to note that certain types of investments can generate large, unpredictable tax obligations at the end of any given year. If you hold these investments in a taxable account, you must pay those taxes in that year, which may require you to either sell some of the holdings in your account or use other savings. However, if your investments were held inside a variable annuity, you would pay no taxes on those returns until after you start taking your money out of the annuity, which could be many years in the future. By deferring taxes, you get to keep all your investment returns at work for as long as possible.

Note: This chart is for illustrative purposes only; the actual difference may increase or decrease as the annual tax rate and rate of return increase or decrease. This hypothetical example should not be viewed as indicative of the past results or future performance of any particular product. Past performance is no guarantee of furture results.

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This gets at the importance of what might be called "asset location." While many people have heard about the importance of "asset allocation," or how your money is spread across different types of investments, fewer people understand the importance of "asset location"--in other words, where those investments are held--in a taxable portfolio or in a tax-deferred investment.

It is also worth noting that you may be in a lower tax bracket after you retire, because your income from Social Security and other sources may be lower than what you had been earning while working. When you reach that stage of your life and decide it is time to end the "growth stage" of your annuity (the years before you take any withdrawals, during which 100% of your investment returns are being reinvested), the taxes you pay on your annuity income could be a lower rate than what you would have paid on investment returns during your working years.

value of the account and your remaining life expectancy, and you pay taxes each year on those distributions.

With an annuity, you can structure the income-generating phase to begin at any age after 59?. Depending on the income you, and possibly your spouse, receive from other sources (Social Security, 401(k)s, traditional IRAs, etc.), you may be able to structure a guaranteed* income stream from your annuity that avoids pushing you into a higher tax bracket. Or, you might want a different approach where you can spend more income early in retirement, for a shorter period of time--maybe to do some traveling, or to help out with grandkids' college tuition or to give as an "early inheritance" to your adult children.

Retirement income on your schedule

The fact that you decide when it's time to end your annuity's growth stage raises another important advantage of annuities: they can offer flexibility with respect to timing your income after you retire. You decide when you're ready to begin receiving income from your annuity. This is called the "income-generating stage." This flexibility can help you reduce your taxes in retirement by delaying income that would otherwise push you into a higher bracket. With a 401(k) or a traditional IRA, you must begin taking payouts from those accounts no later than age 70?. When you reach that milestone, there is a minimum "distribution" you are required to take, based on the total

* Guarantees are backed by the claims-paying ability of the issuing insurance company. Earnings are taxable as ordinary income when distributed and may be subject to a 10% additional tax if withdrawn before age 59?.

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