If someone has tried to sell you an annuity, chances are one of the main benefits that they pushed was the tax deferral. What they didn’t mention is that you could pay at least ten times more in taxes with an annuity than with a taxable mutual fund.
Let’s say that you’re 50 years old and that you and your wife inherit $100,000 that you want to set aside for retirement. You invest it into an annuity and earn 6.5% per year until you retire at age 65. The principal is then over $240,000 and you haven’t paid any income taxes on the $140,000 in gains. You decide to take $10,000 per year in withdrawals and find that they are taxed at a 15% income tax rate so you net $8,500 after taxes each year.
Despite the withdrawals, the principal still grows tax deferred and at, age 90, both you and your wife die. Your son inherits the principal which has now grown to a little over $600,000! Unfortunately, the $500,000+ in gains is taxed to him at income tax rates which results in over $166,000 in taxes, leaving him just $438,000 after taxes. Over your retirement years, you paid another $39,000 in taxes on your annual withdrawals, so the total taxes on the annuity come to about $205,000.
Alternatively, you could have invested the $100,000 into a taxable mutual fund. Mutual funds may pay dividends and capital gain distributions each year that are taxable. Let’s assume your stock fund earns the same 6.5% in total returns, but 2% is in dividends, 2.5% is in long term capital gains, and the price of the fund rises the remaining 2% each year. Although you are in a 25% federal income tax bracket during your working years, qualified dividends and long term gains are taxed at a 15% rate. Over your working years, you end up paying about $15,500 in taxes on the earnings. That leaves you with about $220,000 at age 65 and you want the same $8,500 after tax annual income as in the annuity example.
Fortunately, at retirement you find yourself back in a 15% federal income tax bracket which means that qualified dividends and long term capital gains are taxed at a 0% rate! You only need to withdraw the $8,500 per year and, at your death at age 90, your account has grown to $628,000. Over the years you’ve paid taxes on the earnings, but the rise in the share price added additional gains that have not been taxed. Fortunately, at death your child gets a “step up” in cost basis and that amount is not taxed to him and he can inherit the full $628,000 with no taxes due. Your son happily pockets $190,000 more after taxes than had you bought the annuity.
Despite the hyped tax deferral of annuities, in this example, the lifetime taxes using today’s tax laws come to about $205,000 on the annuity versus $15,500 on the taxable mutual fund! There are many other reasons to avoid annuities, but anyone that suggests that they have valuable tax benefits doesn’t understand the tax laws. The “earnings first” tax treatment of withdrawals, the high income tax rates on withdrawals (vs. lower dividend and long term capital gains) and the lack of a “step up” in basis upon death mean that these tax deferred investments are extremely tax inefficient and could cost you and your heirs hundreds of thousands of dollars in extra taxes.
Both accounts earn a net investment return of 6.5% each year. As annuities typically are more expensive than mutual funds, the annuity would need a higher gross annual investment return. Both mutual funds and variable annuities will have varying returns and the 6.5% return assumption is for illustration only.
From age 50 through age 64, the couple is in a 25% federal income tax bracket (taxable income after deductions and exemptions of $75,901-$151,300 in 2017). From age 65 on, they are in a federal income tax bracket of 15% (taxable income after deductions and exemptions of $18,651-$75,900 in 2017). Under current tax laws, qualified dividends and long term capital gains are taxed at 15% for taxpayers in the 25% income tax bracket and at 0% for taxpayers in the 15% tax bracket. State income taxes vary by state and are not considered.
Upon inheritance, the son has an effective tax rate of 33% on the annuity earnings. Under current tax laws, the 33% federal tax bracket applies to income of $191,651-$416,700. Some of the earnings could be taxed at both higher and lower tax brackets.