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Is Variable Annuity Tax Deferral Worth Paying For Again?

Posted by Michael Kitces on Wednesday, February 13th, 12:02 pm, 2013 in Annuities

Through the 1980s and 90s when tax rates were higher, variable annuities were a popular tool for tax deferral. However, since the late 1990s, the primary focus of the annuity industry has been on risk management instead, offering a series of living and death benefit features that have provided significant guarantees, but at a significant cost. When combined with tax rates that declined significantly with President Bush’s tax legislation in 2001 and 2003, the benefit of tax deferral associated with non-qualified annuities was simply no longer worth the cost.

In a significant shift, though, an emerging new generation of low cost variable annuities, combined with a significantly more progressive tax system since the American Taxpayer Relief Act of 2012, may usher in a new era for the use of variable annuities, especially when the contracts can be used strategically as an asset location vehicle to shelter high-return but tax-inefficient investments. Consequently, while not long ago it was projected to take a decade or two for the benefits of tax deferral to offset the cost, it now can take as little as a year or two for higher income clients! The end result: it may once again be time to seriously consider the cost of variable annuities as an expense worth paying to harness the value of tax deferral.


The Value Of Tax Deferral

The fundamental value of tax deferral is rather straightforward – if you have to pay taxes eventually, it’s better to wait. The longer you defer a tax obligation, the longer you can keep money invested and working for you instead, which creates economic value. Or viewed another way, as ongoing inflation erodes the value of everything (at least a little bit over time), taxes paid with future dollars are cheaper than taxes paid with today’s dollars, all else being equal.

However, while there is real value to tax deferral, its value is often overestimated, as clients (and sometimes their planners) forget that the tax bill will have to be paid at some point, if the money is ever to be consumed. Tax deferral is not tax avoidance… it’s just deferral.

Thus, for example, if a client has an investment worth $200,000 that grew by 10% this year, the gain is $20,000, and assuming a moderate 25% tax rate, will result in a $5,000 tax liability. Of course, that tax liability might be paid now or in the future, but either way if the client ever wants to spend the money in his/her lifetime, Uncle Sam must get his share.

Fortunately, though, as long as the tax bill is deferred, the client can keep that $5,000 growing on his/her behalf. If the investment generates a healthy long-term growth rate of 10%/year, then the economic value of the tax deferral is an extra $500/year of growth in the client’s pocket on that $5,000 tax liability that will someday be handed over. Yet while $500 is certainly better than nothing, it’s notable that relative to the original investment of $200,000, the $500 is only 0.25% (or 25 basis points) of value for each year of tax deferral!

Fortunately, that economic value is 25 basis points per year, which means it can compound to more meaningful value over time. Nonetheless, the value of tax deferral is not significant. If the growth was eligible for preferential long-term capital gains rates, the good news is that the client’s tax liability might only be $20,000 x 15% = $3,000. The bad news is that means the economic value of deferring the gain is even less, at only $300/year on $200,000 or a mere 15 basis points.

The Costs Of Tax Deferral

While 25 basis points (or even just 15 basis points) of value for tax deferral isn’t bad if you can get it without any risk or cost, in practice that is rarely the case, as there are both risks and a number of potential direct and indirect costs to enjoying tax deferral, given how the tax code is written.

Of course, the biggest caveat is simply that maintaining tax deferral – especially in the context of deferring long-term capital gains on an appreciated stock – requires staying invested and exposed to economic risks. In point of fact, the tax code now has a number of rules to force the recognition of tax gains if an investor tries to substantively eliminate the economic exposure of the investment (e.g., by shorting against the box). As a result, the real value of deferring capital gains is often unappealing, especially for a relatively “short term” period, where the value of even a few years of deferral can be overwhelmed by a few weeks (or days, or hours, or even minutes or seconds) of market volatility.

Another challenge of getting tax deferral is the indirect tax cost tied to the fact that most tax-deferred vehicles are ultimately taxed as ordinary income upon liquidation. For instance, with a pre-tax IRA or even a non-qualified annuity, growth that may have been taxed at 15% long-term capital gains and qualified dividend rates might be subject to 25% ordinary income rates instead. Although this challenge can be overcome – for instance, in the earlier example, the $20,000 gain might be subject to another $2,000 of taxation (the difference between 25% and 15% tax rates), but with an economic value of $500/year for tax deferral, this can be recovered in a reasonable number of years. On the other hand, the tax rate spread can be mere severe – therefore requiring a longer recovery period – for those who are going from 0% long-term capital gains rates to 15% ordinary income brackets, or from a 23.8% capital gains rate (including the new 3.8% Medicare tax) to a 39.6% (for IRAs) or even 43.4% (for annuities) top tax bracket.

But perhaps the most significant challenge to tax deferral is the fact that, especially for high income individuals who are saving in excess of retirement account contribution limits, the only way to get tax deferral is to “buy” it by investing in a deferred annuity, with all the attendant costs. In a world where many variable annuities that include living benefit riders and ratcheting death benefits can cost 2%, 2.5%, or more (in addition to underlying investment subaccount costs!), it can take an awfully long time for tax deferral to be worthwhile. Even with compounding, it might take 5-10 years for the value of annual tax deferral to be equal to the annuity’s annual cost, and then another 5+  years to make up and recover for the early years when tax deferral was only worth 25 basis points but the annuity’s cost was 250 basis points. Add on the indirect impact of converting qualified dividends and long-term capital gains to ordinary income, and suddenly there’s a 15-25 year time horizon for an annuity’s tax deferral value to just break even! And the time horizon is even longer if investment returns going forward are lower than historical averages. Not surprisingly, this is why the primary story of annuities for the past decade or two has been about risk management and guarantees, not tax deferral!

Buying Tax Deferral At A Reasonable Price?

What’s changed in recent years, though, is an emerging new generation of ultra-low-cost variable annuities, that suddenly make the equation for balancing the cost of tax deferral again the benefits far more appealing.

For instance, deferred annuities like the Symetra True variable annuity or the Jefferson National Monument Advisor contract have annuity costs that are typically 60 basis points or less (in some cases with institutional investment subaccounts that make the net cost of using an annuity even lower relative to brokerage account alternatives). At costs this low, the breakeven period suddenly drops from a decade or two down to just a couple of years of decent growth.

In addition, in many scenarios the contracts can be used in a more tax-strategic manner. For instance, given the unfavorable indirect cost of converting preferential long-term capital gains and qualified dividends into ordinary income, the annuity might be used specifically as an asset location vehicle to investments that are already subject to ordinary income tax rates, such as various alternative investments, higher turnover active management strategies, or even high yields bonds that generate a high enough expected return to make the tax deferral worthwhile. (Notably, with low return bonds, the deferral simply isn’t worthwhile; at a 2% expected return and a 25% tax bracket, the value of tax deferral is literally only 1 basis point!)

The benefits of tax deferral (for investments with reasonable returns!) are further compounded by the fact that the tax system is now even more progressive (higher rates on higher income) as a result of the American Taxpayer Relief Act of 2012. As the chart below shows, tax deferral is simply even more valuable at higher tax rates, especially when combined with good returns. Given a top individual tax rate of nearly 45% on investment income (including the 39.6% tax bracket, the 3.8% Medicare tax, and the impact of high-income phaseouts on itemized deductions), plus a state tax rate of 10% or more in some parts of the country, the economic value of tax deferral on a 10% gain can be as high as 55 basis points… which means the client may break even in year one! In other words, the breakeven period is cut from one or two dozen years down to one or two dozen months! (Notably, though, clients must still plan to use annuities for the long term or otherwise be prepared to navigate early withdrawal penalties!)

Value of One Year of Tax Deferral at Various Tax and Growth Rates. Value Measured In Basis Points. 

Annual
Growth Rate

Total Federal + State Tax
Rate

15%

25%

35%

45%

55%

2%

0.6

1.0

1.4

1.8

2.2

3%

1.4

2.3

3.2

4.1

5.0

4%

2.4

4.0

5.6

7.2

8.8

5%

3.8

6.3

8.8

11.3

13.8

6%

5.4

9.0

12.6

16.2

19.8

7%

7.4

12.3

17.2

22.1

27.0

8%

9.6

16.0

22.4

28.8

35.2

9%

12.2

20.3

28.4

36.5

44.6

10%

15.0

25.0

35.0

45.0

55.0

11%

18.2

30.3

42.4

54.5

66.6

12%

21.6

36.0

50.4

64.8

79.2

*Assumes one year of growth is subject
to specified tax rate and that the associated tax liability can reinvested in a
future year at the same growth rate.

Conversely, it's also notable that with very low growth rates, the value of tax deferral is literally no more than a few basis points, which means the breakeven period may be "never" with any material annuity expense drag. On the other hand, in such scenarios where returns are low (or even negative) low-cost variable annuities can play another role - the potential to allow capital losses to net against ordinary income gains (a topic that will be discussed further in a future blog post!).

Ultimately, though, the bottom line is simply this: in a world where tax rates are rising at the same time that variable annuity costs are falling, it may be time to once again look at annuities not as a vehicle for risk management, but one of tax deferral, especially for high income clients. While it’s still important not to overvalue the benefits of tax deferral, the reality is that at today’s prices, it simply doesn’t take much for the strategy to significantly enhance client wealth at higher tax and growth rates!

(This article was included in the Carnival of Wealth on Control Your Cash and also the Carnival of Retirement on Midlife Finance.) 


  • Meg Bartelt

    Thanks for your continued focus on the pros *and* cons of tax-deferral. I find in both clients and practitioners that we've swallowed the "tax deferral is good" pill and very rarely examine it in specific application to a client. Some middle-income clients even end up making after-tax contributions to trad'l IRAs because of this belief, and I think that the biggest missing element in the thought process is "you're turning capital gains into ordinary income."

  • http://www.carlsbadwealth.com Scott Nabb

    Great blog!

    It might be worth exploring the added benefit of tax deferral as it may help an investor avoid paying unnecessary taxes. By this I mean, let's say the investor is 3 years from retirement -- plans to use funds from a taxable account during retirement and is paying taxes yearly on the earnings at their higher "still working" tax rate. They pay the $5,000 tax bill in year one on the 10% earned and for the next few years the investment(s) loses value and therefore doesn't produce a tax bill and negates the value earned in year one. Plus, after year three the investor enjoys a lower "retirement" tax rate and the investment begins to do better again. Going forward s/he has a lower tax rate. Therefore, without tax deferral the client could've avoided a larger tax bill in year one by deferring and pushing the liability down the road to a time when their tax rates are lower. This of course may only be possible if the investor knew for certain their income tax rate would be lower in the future due to less income.

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  • Joe

    Interesting article. Would have been much better without the obvious bias...

    1. The focus on ultra low cost always seems to ingore, or at least avoid, the advisor fee. Funny how products with no advisor fee added to them always perform so magnificently.

    2. The paragraph that begins " But perhaps the most significant challenge to tax deferral"...is just ridiculous. Income guarantee riders are RIDERS and therefore optional. Why would a "high income" investor who already has significant retirement assets need an income rider or a death benefit??? If there is no need, the riders should not be added and your cost argument all but dissapears doesn't it?

    I can't beleive you felt compelled to make the point about tax deferral being "simply more valuable" to those in high tax brackets.

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  • Michael Kitces

    Joe,
    Thanks for your feedback. Although I have to admit I'm puzzled by your "obvious bias" comment; most of my writing and public speaking for the past three years has been very critical of the annuity marketplace's product design (this article is a notable exception), and I don't represent or have any affiliation to an annuity company, nor do I sell annuities or even maintain a FINRA license to be paid for an annuity if I wanted to.

    As for advisor fees, certainly they play a role, although the products being cited here were be integrated into an asset management platform for which an advisor is already being paid, which means there would be no incremental advisor fee beyond what the client was already paying for the advisor without the use of an annuity.

    As for the "optionality" of guarantees, while virtually all INCOME guarantee riders are optional, many DEATH BENEFIT guarantees are not. The "base" death benefit built into the contract (and it's baseline no-rider cost) is still a more significant (and more expensive) death benefit than the purely return-of-cash-value alternatives being discussed here. So while consumers can opt out of income guarantees, they can't always opt out of death benefit guarantees. In addition, given that for most of the past decade, variable annuity companies offering guaranteed income riders have had such riders attached to 90%-95%+ of all contracts issued, it seems that in practice consumers have rarely viewed these features as "optional" and there has been little use of variable annuities as a no-guarantee tax deferral vehicle.

    As for the point about tax deferral being more valuable for those in high tax brackets... again, if you actually look at the industry data, the overwhelming majority of annuity buyers are NOT in top tax brackets. So while the point may seem intuitively obvious to you, the behavior of the marketplace makes it clear that unfortunately, most consumers are not connecting those dots, which is why I felt it was appropriate to make the point.

    Respectfully,
    - Michael

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