Measuring the Tax Benefit of a Tax-Deferred Annuity

Babbel, David F.; Reddy, Ravi
October 2009
Journal of Financial Planning;Oct2009, Vol. 22 Issue 10, p68
Academic Journal
•We 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. •We demonstrate how the size of the tax benefit available from tax deferral depends on five factors: 1. The length of time the annuity is held during the accumulation and decumulation phases of ownership 2. Whether a deferred annuity is annuitized at the end of the surrender period or taken as a lump sum distribution 3. The level of yields net of expenses 4. Tax rates on ordinary income 5. The differential between tax rates on ordinary income and tax-preferred treatment of dividends and capital gains •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. •We analyze how the size of benefits from tax deferral will change if the current tax code reverts to the pre-Bush levels, as scheduled. •We provide a set of formulae that can be used to estimate the size of tax benefit arising from tax deferral under varied scenarios.


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