Capitalizing on the tax-deferral advantage of a variable annuity
J.P. Morgan Wealth Management
- A variable annuity is a tax-deferred retirement product that accumulates funds or distributes income based on the performance of the underlying investment options chosen by the contract owner.
- This type of investment can be especially beneficial for individuals in a high tax bracket.
- It may also provide value for individuals who are still planning for retirement, or who expect to be in a lower tax bracket during retirement.
- The longer the deferral period, the more opportunity to grow and accumulate funds, which may result in a greater income stream – which will then be taxed as ordinary income.
In wealth-building 101 there is a very crucial lesson called asset location. The crux of which is: Where you put your money matters. If it’s in a tax-inefficient asset – one where you’re taxed at a higher level or more frequently – then you may want to consider making your money tax-efficient.
A tax-efficient asset allows you to invest and potentially grow more of your money without annual taxation.
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One such potentially efficient asset is a variable annuity. A 2023 report by J.P. Morgan Asset Management analyzes the specific tax benefits of this investment.
What is a variable annuity?
Before we go into the specific tax advantages of a variable annuity, we want to take a step back and explain what a variable annuity is relative to other types of annuities.
In short, a variable annuity is a contract between the holder and an insurance company that offers a range of investment options, typically subaccounts or funds that invest in stocks, bonds, money market instruments or some combination of the three. As such, the value of the investment will vary depending on the performance of the investment options chosen. This is unlike fixed annuities that can accumulate funds or distribute income at a fixed rate and in guaranteed amounts.
Asset location: Is it really that important?
In 2022, the Tax Foundation found that American taxpayers filed 153.8 million tax returns, amounting to $2.1 trillion in individual federal income taxes. Asset location is crucial if investors – especially investors who pay high taxes – want the most from their returns.
An example by J.P. Morgan Asset Management looks at an initial investment of $100,000 over 30 years. This investment is taxed at a 24% rate with a 6.25% compounded annual rate of return.
- When placed in a taxable account (taxed annually), the end balance after 30 years is $402,400.
- When placed in a tax-deferred account with after-tax contributions, the end balance is $492,500.
- When placed in a tax-deferred account with before-tax contributions, the final balance is $616,400 – a 0.7% higher annual return over the 30-year period.
What are the tax advantages to a variable annuity?
A variable annuity is tax-deferred, meaning investors won’t pay any taxes until they begin taking distributions (after the age of 59½ if they want to avoid penalties). This can be an advantage over many other assets, which incur a bevy of current taxes that may include:
- Taxes on interest payments from bonds or money markets
- Taxes on stock dividends
- Short-term capital gains taxes on investments held for one year or less
- Long-term capital gains taxes that are incurred when you sell an investment you’ve held for longer than a year
Although you will still pay taxes on distributions from your variable annuity, these taxes can often come after many years of tax-deferred growth.
What are the tax disadvantages to a variable annuity?
While variable annuities have many tax advantages, there are also potential disadvantages to consider. Contributions to annuities are not tax-deductible and distributions are taxed as ordinary income, so any benefit from lower tax rates (such as on long-term capital gains or qualified dividends) is sacrificed. There are also penalties on early withdrawals from annuities, and there may be limited investment options in a variable annuity.
Who benefits most from variable annuities?
People who may want to pay extra attention to variable annuities are:
- High-income earners
- Those who expect their tax bracket to be lower during retirement
- Those who have 10 or more years until retirement
- Those who have maxed out contribution limits on other tax-advantaged accounts
A variable annuity may be a valuable option for individuals who have exceeded the limits on IRAs and other traditional retirement accounts. These individuals also generally stand to benefit the most from tax deferral, as they pay the highest rate of taxes, and their investment sums may have high growth potential over years or decades.
These individuals aren’t the only ones who benefit from variable annuities, though. Any person saving for retirement can potentially benefit from its years of tax-deferred growth. Especially if that person expects their tax bracket to be lower when they retire. This way, they would end up paying less than if they had paid taxes on the income currently while they were working. Before investing in an annuity, consider consulting with a J.P. Morgan advisor to see how it can fit in your long-term financial plan.
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