Annuities have always been a desirable retirement vehicle. Because of the ever-present fear of outliving their money, retirees have turned to annuities because of their promise to provide “an income that you cannot outlive.” However, annuities have many other benefits than just providing an income for life. Let’s review some of these benefits.
Perhaps the most attractive advantage of an annuity, other than income for life, is that the annuity owner can defer taxes on the growth of assets within the annuity contract. Earnings credited to an annuity are not taxed to the annuitant as income until withdrawn. This tax deferment, along with the benefit of compounding, allows annuities to outperform most other taxable investments. Because of tax deferment, annuities experience a “triple compounding” effect that produces more growth, more quickly. Triple compounding allows annuities to accumulate growth on principal, growth on that growth, and growth on the monies that did not have to be taken out to pay taxes. This creates a higher effective yield.
The Power of Tax Deferral
We have seen how deferring taxes on annuity accumulation is one of the most valuable benefits of a tax-deferred annuity. The following figure shows the amazing difference between asset growth that is taxable during the accumulation period, and that which is not taxable during the accumulation period.
Another advantage of compounding and tax deferral is that the higher the tax-bracket of the client, the larger the spread in future years. Although this seems evident, the spread is in a larger proportion than one might think. For example, using the previous chart, if one person realizes the 5 percent tax deferred growth and accumulates the $338,600 at the end of 25 years, how much more would that person accumulate at a 10 percent assumed annual rate of return (twice that of the 5 percent)? If you were to say $677,200, which is twice the amount accumulated after 25 years at 5 percent, you would be incorrect. The correct amount is $1,083,470.
Therefore, the higher the tax bracket, the higher the spread, and the higher the assumed annual rate of return, the wider the spread in the amount of future monies accumulated because of the compounding effect.
Probate means “to prove” and is the process used by individual states to determine the proper transfer of ownership assets in an estate, as well as to determine the tax liability on those transferred assets. If the deceased has no will, he or she is termed to have died intestate, and the probate courts will determine how the estate is to be apportioned.
The problems with probate are:
1. lack of privacy—The process of probate is a matter of public record. Notice is required to be given to all interested parties so that claims may be brought against the estate.
2. delay—It is not unusual for the probate process to require several years, depending on the size, complexity, and number of claims brought against the estate.
3. cost—Probate can be expensive. Court fees, attorney fees, filing fees, appraisal fees, and fees for executors and/or conservators are often charged. It is not unusual for such costs to amount to as much as 10 percent of the value of the estate, and in many cases much more. This may create circumstances in which it is necessary to sell assets of the estate to cover probate costs.
Taxes on Social Security
In addition to deferring taxes and compounding the earnings (which would normally have a tax liability) during the accumulation years, the annuitant can also control the timing of the taxes that become due as monies are withdrawn from the annuity. By controlling the timing of annuity distribution, the annuitant can control the amount and rate of taxation on his or her Social Security income.
When collecting Social Security, a calculation incorporates a formula for all income, without exclusion for tax-free bonds and other sources of income that may not be included in the normal calculation of taxable income. If under this formula the annual income exceeds a certain threshold amount, then up to 85 percent of the income from Social Security may be taxed. Therefore, controlling the annuity income could play an important part in the tax planning aspect of retirement.
Guaranteed Income Stream
Annuities can provide a guaranteed income stream for a lifetime, depending on the settlement option the annuitant selects. If the annuitant selects an income stream for his or her lifetime, or for multiple lives or joint life payout, then that income stream will continue as long as the recipients of the income are alive. This is true, even though the principal in the annuity has been exhausted. A life annuity maximizes the use of retirement funds and thus guarantees the income stream to last a lifetime.
With non-qualified annuities (annuities that are not part of a qualified plan with pre-tax dollar contributions), part of each income payment is considered a return of premium, or the cost basis in the contract, and is not taxed. This reduces the tax liability of the income stream. Simply, in the payout phase of an annuity, the payments are normally split between the return of premium and the gain in the contract. This is accomplished by using an exclusion ratio. For example, assume that $100,000 had been paid in premiums to the annuity, and that sum had accumulated to $300,000. The annuitant has selected a settlement option with a monthly payment of $3,000. Of that amount, $1,000 would be considered return of premium, or the cost basis in the contract and is not taxable. The remaining $2,000 would be considered the gain in the contract and would be taxable.
The exclusion ratio varies depending on the settlement option the annuitant selects.