Annuities receive tax deferred treatment on interest they accumulate. It is important not to mistake tax deferral with tax free. Interest earned on annuities is tax deferred, not tax free. What that means is that even though the earnings inside the annuity may appear to be tax free, at time of withdrawal the interest is then taxed as ordinary income. Tax Deferral has its positives and negatives
Positives of Tax Deferral
Unlike interest on CD’s the interest you earn, interest on an annuity is not taxable until you withdrawal it. With a typical CD issued by a bank the interest you earn each year whether you take it or not is taxed at ordinary income. Essentially if you earn 5% interest, you have to pay your tax on that interest.
If you were in the 35% tax bracket that means you would only be keeping 65% of the interest that you earn. If you only kept 65% of the 5% interest your effective annual rate would be more like 3.25% interest.
With the tax deferral feature from an annuity you can defer the taxes on your earnings. For example If you earned the same 5% but didn’t have to pay taxes on it, you would theoretically have more money at the end of the year because your true rate of return would be 5% not 3.25%.
At some point however you do have to pay your taxes, whether you take your money out and spend it or whether your beneficiary who receives the money upon your death pays them, the taxes will be paid. The difference is that with the annuity and the compounding effects of interest by delaying paying the taxes your interest can earn more interest on itself.
Negatives of Tax Deferral
In other investments, gains are taxed at what is called capital gains tax. The capital gains tax is generally lower than ordinary income tax. For example the top capital gains tax this year (2009) is 15% while the top state and federal tax is 45%.
Capital gains is the tax owed on the appreciation of an asset held longer than a year. It is not the tax that is owed on interest payments from CD’s and bonds. It is important to note that all interest received is taxed at ordinary income. If you were to purchase a mutual fund for $20 per share and sell it 5 years later for $40 per share you would owe a capital gains tax on $20 per share you owned.
Benefits of Tax Deferral
In the example below lets look at two investments; one in a traditional CD and the other in a CD Type annuity. Lets suppose that we have a 55 year old investor named Joe. Joe has $100,000 to invest and does not need the money for the foreseeable future. Joe is able to earn 5% interest on both of his investments for the next 20 years.
In the CD Joe pays his taxes each year he earns his interest. In the Fixed Annuity Joe is able to defer the taxes on his interest for 20 years at which time he pulls out his money and pays taxes on the entire amount of interest earned. Joe is in the 35% tax bracket. Which one has more money at the end of 20 years?
Traditional CD vs Fixed Annuity - Before tax and After Tax
As you can see the annuity provides a considerable after tax benefit, almost $20,000 extra at the end of 5 years.