Tax Deferred Annuity Advantages

As its name implies, the biggest advantages of the tax deferred annuity derive from the privilege of tax deferral. The ability to invest money and have the gains compound tax free is a powerful tool for building wealth. The three basic types of annuities share a common structure: the holder makes periodic payments that are invested and accumulate over time until a specified future date, at which point the accumulated proceeds are distributed to the holder. In each case, the accumulation occurs free of taxation.  Taxes are due upon distribution. The tax consequences of each of the three types of tax deferred annuity are discussed below.

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Fixed Annuity

The fixed annuity is the oldest and most popular type of tax deferred annuity. It gets its name from the provision in the annuity contract that specifies a fixed rate of investment return on the holder’s investment contributions. (This rate of return will normally be guaranteed, but not for the entire duration of the accumulation period.) The contract also specifies the length of the accumulation period, during which the contributions grow and compound tax free. At its conclusion, the distribution period begins and payments to the holder commence. Distribution via annuity payments, as compared to a lump-sum payment, is another tax advantage since it spreads out the taxes rather than concentrating them in one year.

Taxation also begins at this point. The owner is taxed on the investment gains earned during the accumulation period.  Because a tax deferred annuity is an insurance product, the gains are taxed as ordinary income rather than as capital gains. (Currently, this is disadvantageous, but there have been dramatic historic changes in relative capital-gains and income-tax rates.)

Compare the tax consequences of the fixed annuity with those of the certificate of deposit, which also has a specified duration, fixed rate of return and penalties for early withdrawal. Unlike the tax deferred annuity, however, the CD’s interest income is currently taxable at the federal level and often at lower levels as well. In order to match the tax deferred status of the fixed annuity, the CD would have to be held inside an IRA or similar retirement vehicle. Since retirement accounts have contribution limits, holding a CD inside a retirement account would crowd out alternative investments (such as stocks or mutual funds) that are more conducive to building wealth in the long term.

Variable Annuity

The variable annuity is so-named because the investment returns earned by the holder in the accumulation period are not contractually fixed. Instead, they are tied to investments selected by the holder and whose returns vary according to their marketplace performance. Variable annuities were created in order to allow holders to seek higher rates of return by willingly bearing the risk of greater fluctuation in investment returns.

Apart from the difference in investment vehicle and contractual guarantee of returns, the variable annuity operates the same as the fixed annuity.  Following the tax-free accumulation period is a distribution period in which gains are paid out and taxed as ordinary income.

The most useful comparison is between variable annuities and mutual funds. Indeed, mutual funds are often the investment vehicle chosen within the variable annuity.  Dividends and realized capital gains of a mutual fund are subject to current taxation. Investors can and do achieve tax-deferred status for mutual fund investments via IRAs, 401(k)s and other tax-advantaged retirement vehicles.  Unfortunately, contributions to these accounts are limited.  The tax deferred annuity does not suffer this disadvantage.  Investors who have reached their IRA and 401(k) limits can continue to invest tax-deferred using annuities.

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Indexed Annuity

The investment performance of the indexed annuity is linked to fluctuations in some index of financial-market performance, such as the Standard & Poor’s 500. On the risk-return spectrum, the indexed annuity falls in between fixed and variable annuities.  Unlike the fixed annuity, the interest rate credited during the accumulation period will vary according to the market performance of the index. There are, however, several features designed to confine this variation within certain preset boundaries. These features are designed for people whose risk preferences are intermediate in magnitude.

The tax consequences of the indexed annuity mirror those of the variable annuity.  Compare the indexed annuity to index contracts or an index fund, which are currently taxable. The indexed annuity offers the benefits of tax deferral at the cost of trading capital-gains tax rates for personal-income rates.

Other Advantages

Tax deferral is not the only advantage of the tax deferred annuity. Another advantage is the privilege of annuitization itself, which allows the annuitant to receive a guaranteed stream of income for life. Alternative investments – stocks, bonds, mutual funds, CDs, etc. – do not provide this feature.

The death-benefit feature of the tax deferred annuity, which allows the holder of the annuity to designate a beneficiary to receive any undistributed proceeds in the annuity, is yet another unique advantage. While alternative investments may be bequeathed as part of an estate, the annuity death benefit constitutes life insurance and is therefore exempt from probate. The minimum death benefit is the total amount of payments, less any partial withdrawals.

A tax deferred annuity – whether fixed, variable or indexed – can be designed with a guaranteed minimum feature, in order to assure the holder of a minimum retirement income from the annuity.

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