How strategic withdrawal and tax-deferral can give your clients a huge advantage
by Michael Finke, Ph.D.Mr. Finke serves as a fellow and member of the Alliance for Lifetime Income’s Retirement Income Institute scholars advisory group. Finke is a professor of wealth management and Frank M. Engle Distinguished Chair in Economic Security Research at The American College of Financial Services.
Everyone knows that insurance products are designed to provide financial support if you experience an unexpected loss. Annuities are insurance products designed primarily to protect against the loss of outliving your savings in retirement, an increasingly common risk facing millions of Americans. To encourage consumers to protect themselves against this risk, annuities have tax benefits that can make them more attractive than traditional investments held outside of a tax-sheltered retirement account.
Minimizing your tax burden becomes even more important in retirement when you need to rely on a limited amount of savings and Social Security to fund a lifestyle. All investments are taxed either as ordinary income or capital gains. For example, most higher-income investors are taxed at ordinary income rates that are generally higher than capital gains rates. And when state income taxes are included, ordinary income rates can be twice as high as capital gains. This can significantly reduce after-tax returns on investments whose gains are taxed at ordinary income rates – such as savings accounts, CDs, bonds, real estate investment trusts, or even actively management mutual funds with high turnover. These investments are considered tax disadvantaged because gains are taxed every year at a relatively high marginal rate.
Passive Stock Funds And ETFs
Passive stock funds and ETFs are examples of tax-advantaged investments that grow over time and are only taxed when the asset is sold. The amount subject to taxation is the gain above the purchase price (known in the world of finance as the basis). These tax-favored assets, which I refer to as “basis” assets, are often underappreciated because their tax benefit increases when gains compound over time.
An annuity too can be viewed as a unique type of tax-advantaged, basis asset. Growth in the value of assets held within an annuity is not subject to annual taxation. Gains are only taxed when assets held within an annuity are pulled out, but the flexibility of choosing when to take assets from an annuity can give consumers greater latitude to withdraw funds when their marginal tax rate is lower.
Consider the following example of a simple multi-year guaranteed annuity (MYGA) – a type of fixed annuity that offers a set interest rate for a certain period – which provides fixed returns that are often higher than other safe investments such as CDs. A 57-year-old woman is considering whether to invest in bonds earning a 3% yield to help fund safe spending in retirement. If she invests in bonds, her current 40% state and federal marginal tax rate will reduce her after-tax return to 1.8%. MYGA returns are only taxed when the gains are realized in 10 years, and if her tax rate is still 40% at that time, she would earn a modestly higher 11 basis points of return each year.
However, the basis taxation of the annuity allows her to withdraw gains from the annuity in a potentially more favorable tax environment. For example, if she retires at age 66 and cashes out the annuity to fund spending at age 67 when her tax rate is 25%, the annual after-tax return is 61 basis points higher per year, or a 34% higher annual return. Unlike bonds, current 3% MYGA returns are guaranteed by the insurer and backed up by state insurance guaranty associations. If interest rates rise, bond returns can be significantly less than the 3% yield, adding an additional source of risk.
Additional Tax Deferral Benefit
Annuities also have an additional tax deferral benefit that is often overlooked but can provide significant benefits to retirees who use funds from the annuity to create a lifetime income. If assets that grow within the annuity before retirement are used to fund the purchase of lifetime income annuitization at the start of retirement (to create a base of safe spending to supplement the protected income gap left by Social Security), the amount subject to taxation is only a fraction of the overall income payment.
The IRS uses a so-called exclusion ratio to determine how much of the payment is a return of principal and how much is gains on the original annuity purchase. Because gains are not taxed annually, as they would be on a CD or bond investment, the retiree receives an additional tax deferral benefit that further increases their after-tax annual return.
In general, annuities offer a variety of protected income benefits, and to be sure, the primary benefit of an annuity is not tax deferral. It is to provide lifetime income that a retiree can count on to fund the lifestyle they desire. Still, annuities can provide higher after-tax returns, and should be viewed as icing on the cake that allows a retiree to spend more each year than they otherwise could using less tax efficient investments.