Does tax deferral pay for an annuity's costs? A break-even worksheet

The sales pitch for a deferred annuity often leads with tax deferral: your money grows without a yearly tax bill, and you pay only when you withdraw. That is true, and it has real value. But deferral is not free. A deferred annuity typically carries charges that a plain investment account does not, and when you eventually withdraw, the gains are taxed as ordinary income rather than at the lower rates that apply to long-term capital gains. The question worth asking is whether the tax you defer is worth more than what you pay for the privilege.

Whether it is depends on four things you can put numbers on: how many years the money stays invested, how much extra the annuity costs each year, what tax rate applies to the gains when you take them out, and what the alternative account would have cost you in tax along the way. This worksheet lets you compute the break-even for round assumptions and then repeat it with your own figures. All figures here are invented for the illustration. They are not predictions of returns, and they are not any company's charges.

What this worksheet leaves out

The comparison isolates tax deferral against cost. It does not value an annuity's guarantees, such as a lifetime income rider or a death benefit, which some buyers pay for on purpose, and the guide to are annuities a good idea? covers that wider question. It ignores state taxes, the 3.8% net investment income tax that can apply to high earners, the 10% additional federal tax on gains taken before age 59½, and surrender charges. It also ignores the step-up in basis that heirs get on assets in a taxable account, which an annuity's gains do not receive, as the guide to how annuities are taxed explains. Each of those, if it applies to you, tilts the result further against the annuity or, in the case of guarantees, in its favor in ways this arithmetic cannot show.

The setup

Two accounts each start with $100,000 of after-tax money, which makes the annuity a non-qualified contract with a cost basis of $100,000. Both earn the same 6% a year before costs and taxes. We will compare them after 10, 20 and 30 years.

• The annuity. Its extra cost over a comparable investment is c a year (the mortality and expense charge, administrative fees and any other contract charges, beyond what the underlying funds cost anyway). We will try 0.5%, 1.0% and 1.5%. At the end, the gain is taxed as ordinary income at a rate we will try at 24% and 12%.
• The taxable account, version A. A stock index fund that pays nothing out along the way, with the entire gain taxed at 15% when sold. This is the favorable case for a taxable account.
• The taxable account, version B. Interest-paying investments, such as bonds or a savings product, where the yearly income is taxed at 24% each year and reinvested. This is the unfavorable case for a taxable account.

Step by step, for one cell

Take the 20-year case with an annuity extra cost of 1.0% and a 24% tax rate on the annuity's gain.

Step 1: Grow the annuity. Net growth is 6% − 1% = 5%. Multiply $100,000 by 1.05 twenty times. The result is $265,329.77.

Step 2: Tax the annuity's gain. The gain is $265,329.77 − $100,000 = $165,329.77. At 24% the tax is $39,679.15. The annuity's after-tax value is $265,329.77 − $39,679.15 = $225,650.62.

Step 3: Grow the taxable account, version A. Multiply $100,000 by 1.06 twenty times, giving $320,713.55. The gain is $220,713.55. At 15% the tax is $33,107.03. After-tax value: $287,606.52.

Step 4: Grow the taxable account, version B. After tax, the yearly growth is 6% × (1 − 0.24) = 4.56%. Multiply $100,000 by 1.0456 twenty times: $243,955.99. There is no further tax at the end, because each year's income was taxed as it arrived.

Step 5: Compare. In this cell, the annuity ($225,651) trails version A by $61,956 and version B by $18,305. The annuity's tax deferral did not pay for its extra 1.0% a year.

Now see how the answer moves.

Results across time and cost

All values are after-tax, starting from $100,000, with the annuity's gain taxed at 24%.

Three things stand out.

1. Against a tax-efficient stock fund the annuity loses in every cell. The favorable capital gains rate and the absence of yearly tax mean a taxable account already enjoys most of the benefit of deferral, and a 24% rate on the annuity's gain is higher than the 15% rate on the stock fund's gain. Deferral cannot make up for both a higher final rate and an annual charge.
2. Against interest-type holdings taxed each year, the annuity can catch up. At 0.5% extra cost it passes version B at 20 years and leads by $1,794; at 30 years it leads by $21,743. The break-even is about 18 years. At 1.0% extra cost it never catches up within 60 years at a 24% rate.
3. Cost moves the answer more than most buyers expect. At 30 years, each additional half-percentage point of annual cost takes roughly $44,000 to $50,000 off the annuity's after-tax result on these assumptions ($402,780 falls to $352,468, then to $308,644).

Changing the tax rate at withdrawal

Deferral looks better when your tax bracket falls by the time you withdraw, as it may in retirement. Rerun the annuity column with a 12% rate on the gain, keeping everything else the same:

Compare to Taxable B: at 20 years and 1.0% cost the annuity at $245,490 leads by $1,534, and at 30 years it leads by $11,294. At 10 years it trails by $848. Break-even is about 17 years at 1.0% cost. Against Taxable A, the annuity still trails everywhere: at 30 years and 0.5% cost it ends at $450,588 against $503,197.

So the result swings with the rate at which the gain is eventually taxed. That rate is a guess, since neither you nor an advisor knows your future bracket, and a large annuity withdrawal could itself push you into a higher one.

If the return is lower than 6%

The tables assume 6% a year, which is an illustration and not a forecast. A lower return changes the picture, because a fixed annual cost takes a bigger share of a smaller return, and a smaller gain means there is less tax to defer. Rerun the 20-year Taxable B comparison at 4% gross, with the same 24% rates. The taxable account grows at 4% × 0.76 = 3.04% a year and ends at $182,019. The annuity at 0.5% extra cost grows at 3.5% and ends at $175,224 after tax; at 1.0% extra cost it ends at $161,264. At the lower return, even the cheap annuity trails the yearly-taxed account, where at 6% it led. The break-even you computed at one return does not carry over to another, so redo the worksheet with a cautious return as well as an optimistic one.

How to read these tables

The pattern is not an accident. Tax deferral is most valuable when four conditions line up.

• The money stays put for a long time. Compounding on money that would otherwise have gone to taxes needs many years to add up. In a 10-year horizon the annuity trailed nearly everywhere.
• The alternative generates taxable income every year. Bond interest, a high-turnover fund or anything taxed at ordinary rates each year gives up more to tax than an index fund held for decades.
• The annuity costs little. Plain fixed or index-linked designs without a listed fee have their cost inside the credited rate, so the right comparison is what rate you actually get. Variable annuities and riders stack charges, as the guides to annuity fees, explained and variable annuities: how they work, what they cost, who they suit show.
• Your tax rate drops. A lower rate at withdrawal than during accumulation is what makes deferral worth more.

When conditions are the opposite (a short horizon, a tax-efficient taxable account, a costly contract and a higher final rate), deferral rarely pays for itself. The post on variable annuity fees in dollars converts typical layers into actual dollars so you can fill in the cost line.

Two cautions. First, a retirement account already defers tax, so an annuity inside an IRA adds no extra deferral, and you are paying for something else, such as a guarantee. The guide to Should you put an annuity in an IRA? discusses that. Second, withdrawals from a non-qualified annuity come out gains first, so the tax comes early in your drawdown, as the post on gains-first taxation shows with a worked example.

Two savers, same worksheet

Say Marta, 45, has $100,000 of after-tax savings that she will not touch until she is at least 65. She is in a high bracket now and expects a lower one in retirement. Her taxable alternative would be a bond fund, because she wants stability, so the interest would be taxed every year at her current rate. For her, the 20-year and 30-year rows of the Taxable B column are the relevant comparison, and a low-cost annuity can reasonably come out ahead. She still has to weigh the surrender period, the fact that her heirs would owe tax on the gain, and whether a municipal bond fund or a tax-managed fund would do the same job.

Say Ben, 58, has the same $100,000 and expects to retire at 62 and use it within about ten years. He would hold a broad stock index fund in a taxable account. His row is the 10-year row of Taxable A. The annuity trails by a wide margin at every cost level, and a surrender charge in the early years would add to the gap. The worksheet suggests deferral is unlikely to justify the contract for him, unless he is buying it for a guarantee rather than for tax reasons.

The two savers have the same product, the same dollars and opposite answers. What differs is the horizon, the alternative and the tax path. That is why a seller's single illustration, however accurate, cannot settle the question for you.

How these comparisons get tilted

Be alert to the following when someone shows you a deferral illustration.

• The alternative is a savings account taxed at the top bracket. Comparing an annuity with the worst-case taxable choice, rather than the one you would really use, flatters the annuity.
• Costs are left out or shown only as a footnote. If an illustration shows a gross return without the contract charges, it is not an after-cost comparison. Ask for the version net of every charge.
• The tax rate at withdrawal is assumed to be low. Ask what bracket was assumed and whether the withdrawals were added to your other income.
• The horizon is long. Thirty years is where the annuity does best, and not everyone holds a contract for thirty years. Ask to see 10 and 15 as well.
• The gain is assumed to be withdrawn at once or spread thinly. Gains-first taxation can bring a large part of your withdrawals into the early years, as the worked arithmetic in the post on annuity tax myths shows.
• The step-up in basis is not mentioned. Heirs of a taxable account holding appreciated assets generally receive a stepped-up basis; heirs of an annuity owe ordinary income tax on the gain.

None of these is dishonest in itself. Each is a place where a favorable assumption can hide inside an accurate calculation.

What the arithmetic cannot tell you

A break-even worksheet can say the annuity is behind or ahead on tax and cost. It cannot say whether you value the things money cannot buy in an index fund: a contractual promise of lifetime income, the removal of a decision, or protection from your own impulse to sell in a market drop. Some buyers will rationally pay a premium for those. The honest comparison, then, has two parts: the tax-and-cost arithmetic here, and a separate judgment about the guarantee, covered in the guide to are annuities a good idea?. If you pay for a guarantee you will probably never use, the tax arithmetic is the only return you can count.

Your turn: the blanks

Copy these lines and fill them in from your own contract or illustration.

1. Amount to invest (P): $______
2. Years until you expect to withdraw (n): ______
3. Assumed gross yearly return (g): ______%
4. Annuity's extra yearly cost beyond comparable funds (c): ______% (add the M&E charge, administrative fee, rider fee and any other contract charges; get them from the prospectus fee table or the contract)
5. Tax rate on annuity gains when you withdraw (T_ann): ______%
6. Annuity after-tax value: F = P × (1 + g − c)^n; tax = T_ann × (F − P); result = F − tax = $______
7. Your taxable alternative, if it grows untaxed until sale: V = P × (1 + g)^n; tax = T_cg × (V − P); result = V − tax = $______
8. Your taxable alternative, if its income is taxed yearly at T_yr: V = P × (1 + g × (1 − T_yr))^n = $______
9. Which result is larger, and by how much? ______

A spreadsheet or a calculator with a power key handles the exponents. A fee-only planner or a tax professional can run it with your own bracket and state taxes. If the comparison is close, the annuity's guarantees, or the lack of a need for them, should decide.

Questions to ask the seller

• What is the total yearly cost of this contract in percent and in dollars, including every rider?
• What investment would I hold in a taxable account instead, and what would it cost me in tax each year?
• Is this money in an IRA or other retirement account already?
• What surrender charge would apply if I need the money in year five?
• What do my heirs receive, and how are the gains taxed for them?

Key takeaways

• Tax deferral has value, but it has to cover the annuity's extra annual cost and the higher ordinary-income rate on the gain.
• In the invented example, a non-qualified annuity at 1.0% extra cost trailed a tax-efficient stock fund in every cell and trailed yearly-taxed interest holdings at a 24% withdrawal rate over 20 years by $18,305.
• Deferral works best with long horizons, low costs, a taxable alternative that is taxed each year, and a lower tax rate at withdrawal.
• The worksheet leaves out guarantees, the basis step-up for heirs, the 10% early-withdrawal tax and state taxes, so use it as a floor for the comparison, not the verdict.
• Fill in the blanks with your own figures, and have a tax professional check your bracket before you decide.