Understanding Annuity Tax Deferral

Annuities can offer many advantages when compared to other investment instruments. One of these advantages, and some would say the biggest advantage, is tax deferral.

Annuity tax deferral allows investments to have gains that grow tax free. In other words, the accumulation period is free of tax. The taxes are however due when the distribution period is started for the annuity. At distribution, gains are taxed as ordinary income rather than as capital gains. This treatment is because an annuity is considered an insurance product. Currently, this treatment is a disadvantage to annuities. However, the taxation rules are always subject to change, and have changed drastically over the years. Also, the tax-deferred gains advantage of annuities outweighs the tax treatment difference, especially given long investment terms (10+ years).

It is best to understand the concept of annuity tax deferral with a few examples. A fixed annuity sounds very similar to a certificate of deposit (CD). A certificate of deposit also has a fixed rate of return, a specified contract length, and a penalty for early withdrawal. The main difference is the tax deferred treatment of the annuity. A CD would need to be held inside a retirement account, such as an IRA, to match the tax treatment of a fixed annuity.

With a variable annuity, the investor's premiums are used to invest in underlying assets, usually mutual funds. During the payout period, income payments made to the investor vary in relation to the performance of the separate investment account. In terms of annuity tax deferral, a variable annuity follows the same procedure as the fixed annuity. There is an accumulation period where growth is compounded tax-free. During the distribution period, gains are taxed as ordinary income.

As a comparison, the tax treatment of a variable annuity can be studied against a mutual fund. Mutual fund investments are only considered tax-deferred if they are held within a retirement account, such as an IRA or 401(k). IRAs have contribution limits associated with them. Annuities do not. Often, annuity tax deferral is leveraged by investors who have already reached their contribution limits on their IRA.

The final example, an indexed annuity, earns interested based on an external financial index, such as the S&P 500. Index annuities offer tax deferral benefits equal to variable annuities. In other words, annuities offer tax deferral, but when the tax is paid, it is paid at ordinary income rates. Index funds do not offer tax deferral, unless they are held within an IRA, but income is taxed at a lower capital-gains tax rate. If the index fund is held within an IRA, the IRA is subject to contribution limits which do not apply to indexed annuities.

It should be noted that there is an IRS penalty if a withdrawal is made from a tax-deferred annuity prior to the age of 59 ½, to encourage retirement saving. Currently, this penalty is 10%.

Annuity tax deferral is only one of the advantages offered by annuities. With annuities, investors can elect to receive a life-long, guaranteed income stream. Plus, an annuity can have a death-benefit feature where the holder can designate a beneficiary. The annuity death benefit is exempt from probate since it is considered life insurance.