It’s a given that tax-deferred annuities can reduce an investor’s taxes and produce a tax-savings in the long run — or is it? The issue might not be as clear-cut as commonly believed.
In a paper published in the October 2009 issue of the Journal of Financial Planning (“Measuring the Tax Benefit of a Tax-Deferred Annuity”), authors David F. Babbel, Ph.D. and Ravi Reddy examine the factors that influence the tax benefit of tax-deferred accounts versus taxable accounts.
The authors show “how to measure the size of the tax benefit arising from the purchase of fixed annuities relative to holding a taxable account composed of stock and fixed income assets, whether traditional or equity-indexed or for deferred and immediate annuities.” They show how the size of the tax benefit realized depends on the interaction of five factors:
- The length of time the annuity is held during the accumulation and decumulation phases of ownership,
– Whether a deferred annuity is annuitized at the end of the surrender period or taken as a lump sum distribution,
– The level of yields net of expenses,
-Tax rates on ordinary income, and
-The differential between tax rates on ordinary income and tax-preferred treatment of dividends and capital gains.
It’s an interesting analysis, and the authors also find that:
– The effect of tax deferral can be positive or negative, depending on how these factors interact.
– Under some circumstances, the benefits from tax deferral can amount to the equivalent of earning more than 200 extra basis points per year relative to the taxable alternative.