Like most things, taxation ebbs and flows. Today's environment is no different—and it appears that, for now, taxation is on the rise. The American Taxpayer Relief Act of 2012 and the Affordable Care Act both affected tax rates for high-income earners at the federal level—a change that will affect numerous households as they prepare their 2013 tax returns. Compounding these changes are rising taxes at both the state and local levels. In this environment it's important to consider tax-deferred and tax-favored savings strategies in your financial plan. When the tax burden on individuals rises, the importance of tax deferral for those with high net worth becomes especially important. The question then becomes: How can individuals take advantage of tax deferral beyond contributions to their retirement accounts?
Used strategically, variable annuities can be an alternate method for preserving wealth and supplementing retirement savings while providing beneficial tax treatment. A variable annuity can be designed to meet an investor's income tax and retirement planning objectives.
What Is a Variable Annuity?
A variable annuity is a long-term, tax-deferred investment designed to fund retirement. It allows you to diversify your savings by choosing from a selection of investments that provide potential capital growth while also providing you with an income stream over time—sometimes for the rest of your life. Unlike other tax-deferred investments, deferred annuities have no IRS contribution limits, so you can invest as much as you want in them to help fund your retirement. However, variable annuities do involve risk, and they may lose value. Earnings are taxed as ordinary income when they're distributed and may be subject to a 10 percent penalty if they're withdrawn prior to age 59½. Variable annuities represent a contract between an individual and an insurance company. They have diverse features and may provide solutions to a wide range of financial needs—they defer taxes, generate income, and can help families create a legacy.
Tax deferral has been a primary benefit of deferred annuities since their inception. By using variable contracts, individuals can invest their excess savings in a diversified basket of investments while deferring their taxable income to a later time. This allows investors to maintain their current risk posture and investment strategy while enjoying potential improved performance and eliminating the drag of taxation on their overall returns.
The basic premise of tax deferral—and why you'd want to take advantage of it—is simple: The longer you defer, the longer your investment can grow and work for you. Time value of money teaches us that a dollar today is worth more than dollar in the future, because you begin earning a return on the dollar as soon as you receive it. Tax deferral is a way to keep more dollars in your portfolio earlier, and as a result it's often better and cheaper to pay taxes later.
Today's tax environment has brought us full circle and back to the benefits of a no-frills annuity. We've returned to the basics. A low-cost annuity will enhance and compound the benefits of tax deferral, especially for high-income earners. The combination of deferred taxes with low expense costs can outweigh the challenges of income taxation within a few years, when once it took decades to recoup the benefits of tax deferrals.
Guaranteed Income Riders
One of the biggest challenges facing those in retirement is the risk of outliving their money. Americans are healthier and living longer, and although longer life expectancy is a good thing, a long life is usually accompanied by a long retirement. Equities, fixed income, and other investment products are not substitutes for guaranteed income, and that's where variable annuities with guaranteed income riders—treated as an asset class of their own in this market—come in. For an additional cost, these riders ease the concern of outliving your retirement savings by guaranteeing minimum income even if the markets decline, providing growth in your retirement by locking in market gains.
Looking at guaranteed income riders as their own asset class—and the portfolio impact they can provide—is where the real value of this unique offering surfaces. Adding a guaranteed income allocation can not only reduce overall portfolio risk but could generate potentially greater income, since they enable income protection with fewer financial assets. Individuals whose basic expenses are covered by guaranteed income can keep their discretionary funds invested in equities for a longer period of time, gaining the benefits of their historically higher returns. Guaranteed income riders provide portfolios with additional sustainability and durability by distributing the risk of outliving your savings across a large group of policy holders. The added flexibility means you can take on additional risk (if desired) or simply allow your invested equity positions to remain invested longer, avoiding drawdowns at inopportune market moments.
Are Annuities Right for You?
It all depends on your situation. Annuities can be a good option if:
You want to increase your tax-deferred earnings and are already taking full advantage of all available 401(k), IRA, or other tax-deferred plans.
You want to receive guaranteed income for life or a set period of time.
You want downside protection within your asset allocation and a dependable income stream.
Whether you're looking for simple tax deferral or downside protection, annuities can deliver by bringing tax benefits, flexibility, and diversification to a portfolio. In today's market, this simple strategy can not only save taxes but also enhance and preserve your wealth.
We're Here to Help
For more information about annuities and guaranteed income riders, contact your Moss Adams Wealth Advisor. We can examine your personal financial situation and goals to determine whether variable annuities or guaranteed income riders could improve your tax situation, then help you implement a strategy that works for you.