Deferred Annuities ExplainedA deferred annuity is a tax-efficient way of saving, at the end of which you can withdraw your money as an income stream or a lump sum. If you take your lump sum before you reach 59.5 years of age, you will have to pay 10% extra tax on your investment gain.
The gains an annuity makes - regardless of whether the gains consist of interest paid or dividends received - are not taxed until they are withdrawn from the annuity. They can therefore be reinvested tax-free. This allows your money to grow faster than normal. The deferred aspect of tax is the same as for IRAs and 401(k)s.
When you try to cash in your gain, your interest or dividends (not your invested capital) will be taxed as ordinary income at the time you withdraw it.
Tax deferral works well if your tax rate does not change. It works even better if you are paying a high rate of tax during the accumulation phase and a low rate of tax during the withdrawal phase.
Tax Deferral Example
Here's a simple example to illustrate the benefits of tax deferral. Imagine you have $1000 to invest. You receive 10% interest each year and your tax rate is 25%.
After one year, your tax deferred fund will have earned $100 of interest. Your pot of tax deferred money will now be worth $1100. After one year, your tax paid fund will have earned $100 of interest, from which $25 tax will be deducted. Your pot of taxed money will now be worth $1,075.
Now imagine this process continues for 20 years. At the end of the 20th year, your tax deferred pot of money will have grown to a value of $6720 while your tax-paid investment will be worth just $4250.
If you now withdraw all your money from both plans, you will get $4250 from the tax-paid investment without further tax to pay. In the case of the annuity, you'll pay ordinary income tax on the gain. The gain is $5720. After paying 25% tax on the gain, you are left with a gain of $4290. Then add in your original $1000, which is not taxed.
Your pot of money is worth $5290 with an annuity compared with $4250 without tax deferral. If you are currently a high rate taxpeyer and will be a lower rate taxpayer when you access your annuity, the outperformance of the annuity will be even greater than in the example.