Annuities are sold to investors based on the promise of tax benefits. I am here to tell you that annuities are more of a liability than a benefit. Annuities do not provide a tax deduction when you buy them. The money you invest will grow tax deferred, but is this a benefit or is this more of a tax liability? I am in the camp that an annuity will cost you more in taxes over the long run.
Annuities do provide tax deferred growth; however the tax liability of this growth will be greater when the annuity is sold due to the fact that they do not enjoy capital gains treatment. All the gains from annuities are taxed as ordinary income. Annuities also do not pass tax-free at death. These are the two main reasons I question anyone who tries to tell me that owning an annuity will save money in taxes. Let’s look at a couple scenarios.
Investor number one invests $500,000 in an annuity with the promise of tax-deferred growth. The annuity grows at a net rate of 7 percent over a 20 year period to a value of $1,934,842 for a gain of $1,434,842. If the investor sells the product the entire gain will be subject to ordinary income tax, which would be at the highest marginal tax rate of 39.6 percent. If the investor dies after the 20 years, the heirs would also be subject to this tax liability.
Investor number two invests $500,000 in the S&P 500 outside of an annuity or IRA. The money will not grow tax deferred. The S&P 500 grows at 7 percent over a 20 year period to the same value as the annuity of $1,934,842 for a gain of $1,434,842. Investor number two will only be subject to a long term capital gains rate of 20% if the investment is sold. On top of that, should investor number two die, all the money will pass on to the heirs without any tax liability due to cost basis step up rules.
The bottom line is that investor number two will have about $280,000 more than investor number one after the 20 year period due to the tax ramifications of an annuity. If both investors die at the end of the 20 years that number jumps to over $568,000 in tax savings for the heirs of investor number two. This only applies to mere tax savings. If you added up all the expenses that come with annuities, the amount of money that investor number two has at the end of 20 years will increase even more.
Please make sure you do your own research or consult with an Independent Investment Advisor prior to making any investment. Investments that are sold through insurance companies usually have higher fees and expenses and are not subject to FINRA or SEC oversight depending on the product. Please contact Jay Chapman, CFP® at 772-266-3431 if you own or are thinking of buying an annuity or any other insurance product.