Understand the Advantage of Tax-Deferred Investment Growth of Deferred Annuities
Sometimes, investors don;t understand the benefit of tax deferral. They believe if they need to pay the tax eventually, what difference does it make to defer the tax. This article explains the benefit clearly so you make the right decisions with IRAs, annuities and other tax deferred opportunities.
The secret to growing your investments is its compounding rate. The higher it is, the faster your investment grows. But that’s only half the story. Increasing the compounding rate from 6% to 8% will produce more than that 33% increase in your investment over the years -see first table. That’s the magic! And that’s why tax-deferred investments are such an advantage. Let’s take a look at some results…
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Per Cent Greater Accumulation for 8% over 6% Compound Rates of $10,000 |
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|
Year |
6% |
8% |
% more |
|
5 |
13,382 |
14,693 |
10% |
|
10 |
17,908 |
21,589 |
21% |
|
15 |
23,966 |
31,722 |
32% |
|
20 |
32,071 |
46,610 |
45% |
|
25 |
42,919 |
68,485 |
60% |
|
30 |
57,435 |
100,627 |
75% |
Taxable accounts are those that generate interest or dividend earnings that are subject to annual taxation. If your investment return is 10% and your income tax bracket is 28%, then 28% of that 10% (i.e. 2.8%) of that investment return is lost to taxation. This leaves only 7.2% (rather than the full 10%) as the compounding rate of that investment.
But tax-deferred accounts suspend yearly taxation of such earnings. So, no taxation would reduce the 10% investment return and it would remain the compounding rate.
Recognizing taxation’s effect on compound rates, we’re interested now in how much higher an earnings rate must a taxable account have to match the growth of a lower earnings tax-deferred account. And this depends also on the tax bracket of the investor.
This is important to retirees who may be interested in putting money aside to purchase an immediate annuity in later years in case they live longer than the expected. Should they put their money in secure investments like treasury bonds or in a deferred annuity to grow for the day they’ll need it. Often, such secure investments grow through earnings that are subject to yearly taxation – as are bonds. They need a basis for comparing the growth rates of different investments.
Your tax bracket determines the tax rate on those extra earnings you receive. So your bond interest earnings would be added to your normal income – from part-time work, your pension, and possibly your social security if taxable and be subject to your (highest) tax bracket. The tax brackets range from 10% to 35%.
The table shows what taxable earnings rate (i.e. subject to yearly taxation) you must receive to achieve a compounding rate equal to the tax-deferred earnings rate based on the tax bracket those taxable earnings are taxed at.
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Taxable Earning Need to Compound Equally to Tax-Deferred Earning |
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|
Federal Income Tax Brackets |
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|
10% |
15% |
25% |
28% |
33% |
35% |
|
|
Tax-Deferred Earnings |
Equivalent Taxable Earnings at Each Tax Bracket |
|||||
|
8% |
8.89% |
9.41% |
10.67% |
11.11% |
11.94% |
12.31% |
|
7% |
7.78% |
8.24% |
9.33% |
9.72% |
10.45% |
10.77% |
|
6% |
6.67% |
7.06% |
8.00% |
8.33% |
8.96% |
9.23% |
|
5% |
5.56% |
5.88% |
6.67% |
6.94% |
7.46% |
7.69% |
|
4% |
4.44% |
4.71% |
5.33% |
5.56% |
5.97% |
6.15% |
Want a quote on deferred annuities’ earning rates? Just use the deferred annuity calculator.
Note that annuities once annuitized cannot be surrendered for value. Income from deferred annuities is taxed as ordinary income and withdrawals prior to age 59 ½ are subject to a 10% penalty. Income from annuitization is taxed part as ordinary income and part as return of capital. Any guarantees are based on the claims paying ability of the insurance company. Annuities should be considered long term investments. Annuities are insurance products and subject to insurance related fees and expenses.
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January 30th, 2009 at 5:33 pm
It is clear that the tax deferred annuities compound at a much more favorable rate than the taxable earning instruments. My one concern with the tax deferred annuities is the penalty for early withdrawal. Many young people today can’t foresee any financial stability and thus would be tempted to take money out when times are rough.
November 9th, 2009 at 4:27 pm
Annuities can be good in many was, but as a tax preparer I will admit I try to talk people away from them.
January 25th, 2010 at 8:23 pm
It is clear that the tax deferred annuities compound at a much more favorable rate than the taxable earning instruments. My one concern with the tax deferred annuities is the penalty for fashion
early withdrawal. Many young people today can’t foresee any financial stability and thus would be tempted to take money out when times are rough.