Top 3 annuity tax myths –and why they need a second look
Aside from Social Security and pensions, annuities are one of the only ways Americans can generate protected lifetime income in retirement. Yet, despite this distinctive benefit, investors often confess to not understanding annuities or how they work. In fact, according to recent research by the Alliance for Lifetime Income, three in 10 investors do not know enough about annuities to associate any benefits with them.* Even if they do consider themselves knowledgeable about annuities, having learned about them from the media or other sources, investors may still be misinformed, especially when it comes to taxes.
Below are three myths associated with annuities and how tax-deferral makes it important to give them a closer look.
Myth 1: Annuities don’t provide enough investment control.
Some investors think that, unlike a brokerage or managed money account, an annuity locks them in and doesn’t provide their financial professional with the freedom they need to perform trades, rebalance investments or manage their money effectively. The opposite is actually true.
Annuities offer many of the same kinds of investments available in other types of accounts – plus a level of protection.
If access to a wide variety of investments is the hang-up to annuities, financial professionals and consumers may want to think again. Today’s annuities offer a wide range of investments, including stock, bond and index funds, asset allocation portfolios and alternatives. Annuities may also be seen as an alternative to other, more traditional, investments. For example, according to CANNEX and the Alliance for Lifetime Income, financial professionals are reimagining the traditional 60/40 stock/bond mix, allocating 20% of assets to bonds and 18% to annuities instead of a full 40% to bonds. When investors were asked to design a portfolio for themselves, they allocated more money to annuities than bonds, with 13% to annuities and only 10% to bonds. Many annuities also offer some protection against market declines or guaranteed growth regardless of market conditions. And, since 91% of investors feel that it is important to protect their retirement income, annuities may be a good choice for a portion of their portfolio.*
Trades within an annuity are tax free, so investors can feel comfortable reallocating or rebalancing at any time.
Annuities are tax-deferred, meaning investors won’t pay taxes on earnings until the money is withdrawn, typically at retirement when the investor is in a lower tax bracket. Therefore, unlike a taxable account, investors won’t pay current taxes on trades or unrealized gains within funds. That means they can buy, sell or rebalance their account as needed. This can be a huge benefit to financial professionals who actively manage their clients’ accounts because it takes tax consequences out of the buy/sell decision and frees them up to trade as necessary.
Myth 2: Annuity investors pay higher income tax rates.
With a brokerage account, investors pay capital gains tax on gains or distributions each year, whether they realize those gains or not. With an annuity, they’ll pay ordinary income tax on earnings when they withdraw them, typically in retirement. As of 2022, short-term capital gains tax rates are lower than income tax rates. However, that might not always be the case. Even if it is, an annuity’s tax deferred status gives it an added advantage.
Capital gains rates may overtake income tax rates.
Investors won’t pay top marginal income tax rates on all their income.
Even if they reach the highest tax bracket, investors won’t pay the top income tax rate on all their income. Instead, their money is divided into different tax brackets that increase as they earn more. Here’s an example:
Retirees are often in a lower tax bracket.
Many retirees move to states with lower or no income taxes or simply need less income in their later years, which means they’ll be in a lower income tax bracket than they were when they were working.
Tax deferral may be worth the higher rates.
According to a recent Equitable survey of financial professionals, 61% of Equitable financial professionals and 83% of other financial professionals said that it was extremely or very important that retirement savings products enable investments to grow tax deferred.**
Myth 3: Annuities take away income control.
Some people may think that taking income from an annuity means losing control of their money altogether. That isn’t necessarily the case.
Annuitization isn’t the only way to get income.
While annuitization is one way to generate protected lifetime income from an annuity, and it means turning assets over to the insurance company in exchange for a lifetime income guarantee, it isn’t the only way to get the income an investor may need in retirement. These days, annuities offer all kinds of ways to generate income, such as withdrawals for life or income for a certain number of years.
Some annuities offer tax-efficient income payments.
If tax control is important, investors may want to consider an annuity that offers income payments that are part principal and part earnings. Typically, the first income payments from an annuity will come from the earnings within the account, so the investor will pay tax on the whole payment. However, these days, some annuities stretch the tax burden over a longer time frame by offering payments that are equally principal and earnings.
Protected lifetime income may be worth it.
Investors may want to keep in mind that only a portion of their assets should be invested in an annuity. And because an annuity is one of the few ways to generate protected lifetime income, the loss of control over some of their assets might be worth the comfort of knowing that they’ll have income for as long as they live, regardless of how long that is. In fact, when asked about their interest in owning an annuity that provides guaranteed lifetime income, an overwhelming majority (85%) said they’d like to own one or already do. Of those who were interested in owning an annuity, 49% said they were extremely interested.*
Annuities and their tax-deferred status may deserve a second look.
While annuities aren’t for everyone, they are a good option for many people these days, especially if they want protected lifetime income in retirement. For years, annuities were pegged as too restrictive for those who were looking for control over investments, taxes and income. But today’s annuities, with their tax-deferred features, provide more flexibility and control than investors might think, making them worth a closer look.
* CANNEX/Alliance for Lifetime Income, “Protected Retirement Income & Planning Study,” July 7, 2021
** SCS Dual Direction & Stop Loss Survey, Equitable Insights, August 2019
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