‘Tis the season o’ taxes. The time in which many investors are reminded that those wonderful “services” the government provides don’t come free. After a visit to their accountant, we are betting many investors who had to reach deep into their pockets are wondering how they can invest in a more tax-efficient manner. And, for those targeting retirement, many financial professionals, insurance agents and others are all too happy to oblige by selling you an annuity. The trouble with this logic? The solution is worse than the problem.
Yes, if you buy an annuity in an after-tax account, the money you plug in grows on a tax-deferred basis. In English, that means you won’t pay capital gains taxes. You won’t pay tax on dividend or interest income received in the annuity. The money grows without tax until you withdraw. The money held within this contract grows like funds in an IRA or 401(k), which is also why the SEC and FINRA have often admonished investors against putting annuities in IRAs.
Now, all of the preceding paragraph is correct, and it is often the pitch those hawking annuities as your personal Panamai want you to bite on. And those hawking annuities as a fix reducing the tax liability associated with your retirement assets will likely trump this up during the season o’ taxes. But there are many problems with this. For one, that tax-deferred “growth” may not actually be so very growthy. But also, the taxes aren’t eliminated forever, and when you withdraw, you might be in for an unpleasant surprise.
Annuities unquestionably provide tax deferral, but you should question exactly how this product will deliver the growth the statement “tax-deferred growth” claims. There are three major types of annuities, and all three have features that typically stunt returns.
One, the fixed annuity, is basically a watered-down, very restrictive, certificate of deposit-like return. It is a fixed rate that will hinge on prevailing interest rates. As we type, a one-year Treasury bond yields 0.54%. A 10-year Treasury, 1.92%ii. The interest rate environment is ultra-low, suggesting rates on fixed annuities are unlikely to be very attractive (at least beyond the initial year—insurers often offer “teaser” rates to get you to buy in, only to have this adjust sharply lower thereafter). So the question here is, how much growth do you need for retirement? Does the tax deferral matter much if you are not on a path to reaching your long-term goals?
Another, the variable annuity, offers several mutual-fund-like subaccounts underneath the insurance contract. You can invest in stocks, bonds or some mix via these subaccounts. The trouble is, the variable annuity contracts can have big fees, and these subaccounts slap another fee on top—a fee sometimesin excess of similar mutual funds. It is not uncommon to find variable annuities with annual fees of 3% or more! These fees greatly hamper returns. How much are you willing to pay to try to dodge Uncle Sam? What if the amount you’re paying for the annuity in excess of a non-insurance product exceeds your tax bill?
Finally, there is the equity-indexed annuity, which is basically a fixed annuity with a fluctuating interest rate that hinges on market performance, typically stock market index performance. The question here: How is the rate actually calculated? Does the market index performance include dividends? Are there caps or limits on how much growth you’ll be credited? How do those work? There is no free lunch in investing. Period. These contracts don’t expressly carry fees outright, but their calculations slice off so much return that many of them wind up no better than a fixed annuity’s CD-like return.
Another consideration here is the long-run wager you are making: By putting after-tax funds into a tax-deferred annuity, you are wagering your tax rate will be lower when you withdraw than it is now. Here’s why.
While annuities defer capital gains and dividend/interest taxation, when you withdraw the funds (typically by turning the annuity into a stream of payments—a process called annuitizing), all of the gains are taxed at ordinary income tax rates. Most argue that if your income tax bracket falls by the time you withdraw, then you’ve won—you deferred taxation in your higher-earning, higher-bracket years and got taxed on it at lower marginal rates.
But it really isn’t that simple.
You see, if you left the funds in an after-tax account, you would be taxed annually on realized capital gains (sales when you earn a profit) and dividends/interest. However, these are frequently taxed at less-than-income rates. So the income tax victory isn’t really an accurate comparison. Furthermore, you can offset realized gains with realized losses, should you have any. While no one likes losing money, an appropriately diversified portfolio will likely have some positions that are at a loss. That isn’t fun, but the tax benefit can be a silver lining.
Moreover, if you have an after-tax account, when you withdraw needed funds, that action isn’t a taxable event. Selling a security or receiving a dividend to generate the cash may be, but the withdrawal is just like taking money from your savings account. The advantage this provides you as a retirement investor? Flexibility. If you have a 401(k) or an IRA, then you have one vehicle deferring taxation that may have consequences if you withdraw money. In an annuity, you are duplicating this. If you have after-tax retirement savings in addition to a 401(k)/IRA, you can manage the amount of taxable withdrawals you take.
All in all, the tax-deferred growth “benefit” many use to pitch annuities is a whole lot weaker than you might think at first blush.
iYes, this is a Panama Papers joke. Too soon?
iiSource: FactSet, rates as of 4/25/2016