Tax Deferred Annuities

Annuities are very attractive cash accumulation vehicles because they're tax-deferred – that is, the taxes due on their earnings is deferred until that time when funds are actually drawn from the annuity and paid over to the owner or annuitant.

By contrast, the earnings credited to certificates of deposit (CD's) are reported to the Internal Revenue Service when credited, and taxes are due on those earnings for the year they're reported, even if they're never in the possession of the owner, but simply rolled over into a new CD.

Non-deferred taxes

The effect of taxing interest income in the year it's earned is to reduce the effective rate of interest. For example, consider a one-year CD of $100,000, paying 4% simple interest. At the end of the year, the Cd matures and earns $4,000 interest, which is reported to the IRS. If the owner of the CD pays federal income taxes at an effective rate of 22%, then the tax liability incurred by that CD is $880. The amount of interest that the owner really stays with is $3,120, which means that the CD's effective interest rate is 3.12% - quite a difference from the 4% paid out. It also means that an annuity paying less than 4%, but more than 3.12%, is a better choice of investments.

This is the same principle used when comparing the effective interest rates of corporate bonds with government bonds. Government bonds – tax free in at least one jurisdiction and often in two or three - pay a lower interest rate than corporate bonds, but remain competitive because their owners won't have to pay any income tax on the interest, whereas with the corporate bonds they will. All it takes to determine which is the better investment is a knowledge of one's own effective tax rate (that is, the ratio of actual tax liability to adjusted gross income). Likewise, the annuity purchaser can determine whether it's more profitable to purchase a CD or an annuity.

Drawbacks to tax deferral of annuities

While tax deferral is an advantage to the purchaser of an annuity, especially for the term of the annuity, it can have its drawbacks, and the prudent purchaser will be aware of them before writing a check. Since many annuities are sold as cash accumulation vehicles to fund retirement, the assumption has been that when the time comes to draw on the cash (either in the form of an annuitized benefit or as a plan of periodic withdrawals without converting the principle amount), the owner (or annuitant) wouldn't be earning income from employment, and thus would be in a lower tax bracket. The benefit of tax deferral in this scenario is obvious – why pay tax today at 42% when you can wait twenty years and then pay it at age 63 at 23% (or whatever)? There a couple of problems with this approach, however. First of all, the owner might need to withdraw funds early to deal with an emergency. If the owner's still working, the interest on the annuity will be added to his regular income and taxed at that rate – in fact, it might even push him to a higher bracket. In addition, if the funds are withdrawn before age 59½, significant tax penalties are imposed that'll more than outweigh any advantages that tax deferral gave the amount withdrawn. (In addition to taxes and tax penalties on early withdrawals, the insurer may also impose a significant penalty on funds withdrawn before maturity.)

A second problem is that some people who've been very successful in their financial life and retirement planning can expect to retire with a greater monthly income than they earned while employed, so that their tax liability is greater in retirement than while working.

The greatest drawback of tax deferral for annuities, however, has to do with the tax treatment of the income earned by an annuity when the owner has died and the annuity is paid over to a beneficiary. While most inheritances are free of tax (at least up to the estate tax threshold, currently $3.5 million), annuities aren't considered inheritances, and the income they earned (as well as the principal, if tax-qualified) is taxed to the beneficiary as ordinary income. The reason this is such a problem is that most annuities are held until the death of the owner and then passed along to the beneficiaries – less than ten percent of all annuities are annuitized.

The role of due diligence

Thus, while the favorable tax treatment accorded annuities makes them a superior choice to similarly-priced competing investment choices, due diligence must be exercised by annuity purchasers and owners to ensure that they won't be penalized coming out of an annuity by the same feature that was a benefit going in.