Aside from the fact that the newest tax rates have a less than six-year lifespan, the tax issue that continues to be missed by annuity critics is that income tax rates–new and old–are marginal rates.

Furthermore, our system of income taxation in this country is a graduated system. So when an investor is ready to retire and begin receiving income, it is unreasonable to assume that 100% of the income distributions from an annuity will always be taxed at the investors highest marginal income tax rate.

Presumably, the income from the annuity is being used to replace some of the compensation that existed prior to retirement. And just like pre-retirement income, the various marginal rates on retirement income–which are graduated as income increases–mean that the overall average tax rate for that investor will be less than the highest marginal rate.

In other words, if someone has $50,000 of annuity income annually at retirement, it is not realistic to assume that all $50,000 will be taxed at the taxpayers highest marginal income tax rate.

For example, some might be taxed at 10%, some at 15%, some at 25%, and so on. Put another way, if the taxpayer paid, on average, 20% in taxes on his total compensation when he was working, why should we assume his average tax rate on his retirement income–which includes annuity distributions–would be any higher? If you agree with this premise, the post-tax cut argument the critics have against annuities is greatly diluted, and tax-deferral is still a valuable benefit for many long-term investors.

–David Foster

Reproduced from National Underwriter Life & Health/Financial Services Edition, August 4, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.