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Measuring the Benefits of Tax-Deferred Annuities

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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.

– This tax advantage can be reduced or increased by embedded expense differentials between insurance products and alternative investments, depending upon the products employed.

Further analysis looks at how the size of benefits from tax deferral will change if the current tax code reverts to the pre-Bush levels, as scheduled. A set of formulae is provided that can be used to estimate the size of tax benefit arising from tax deferral under varied scenarios.

There are many situations when the tax benefit of a tax-deferred annuity outweighs those of a taxable account. This tax benefit can result in an annual yield spread of 2 percent or more, depending on how long the annuity is held, how high the yields are, and whether annuitization occurs as one reaches the end of his or her accumulation period.

This analysis shows two polar cases in which the tax-deferred annuity always has the tax advantage:

- For individuals who are more risk averse and therefore prefer to invest in less risky assets, which generate ordinary income. Even for individuals who prefer to hold a portion of their assets in vehicles that produce tax-preferred income, the remaining assets that generate ordinary income provide better after-tax returns when they are in tax-deferred vehicles such as tax-deferred annuities.

- For individuals seeking to convert their investments into immediate annuities to replace or add to retirement income. Payout through an immediate annuity extends the tax advantage as the conversion to a tax-deferred annuity can be done through the exercise of a contractual option within the deferred annuity, or through a 1035 exchange that does not result in an immediate tax event.

Therefore, the taxes are deferred until the income is actually received. Of course, taxes are also deferred for anyone who systematically liquidates the taxable account over time as retirement income. However, in a volatile interest rate or stock return environment, such an approach subjects the individual to the yield erosion associated with reverse dollar-cost averaging, and this cost can be substantial.

If the delay occurs over a market downturn, there may be inadequate resources remaining to guarantee an adequate lifetime income. It also subjects the individual to uncertainty regarding future annuity purchase rates.

In both cases, independently or together, the tax-deferred annuity can provide the investor with a tax advantage. Additionally, by converting the investment into an immediate annuity instead of opting for a lump-sum payout, the individual also is protected from longevity risk.

The paper is available online.

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