What is a Tax Deferred Fixed
The most simple definition of
a tax-deferred fixed annuity is a long-term retirement vehicle that provides
several tax advantages. More specifically, it's a contract between you and an
insurance company for a guaranteed interest-bearing policy. This policy also
guarantees certain income options. What the insurance company does is it credits
interest to your principal, and you don't pay taxes on these earnings until you
make a withdrawal or begin receiving an annuity income. Simply, your annuity
earns a competitive return that is very safe and
backed by the claims paying ability of the issuing
What's the advantage of
Tax-deferred means postponing
your taxes on interest earnings until a future point in time. In the meantime
you earn interest on the money you're not paying in taxes. You can accumulate
more money over a shorter period of time, which ultimately will provide you with
a greater income.
Many people today are choosing
tax-deferred annuities as the foundation of their overall financial plan instead
of certificates of deposit or savings accounts. Although CD's and annuities are
very similar there are significant differences between the two. The most
important difference is that annuities allow for the deferral of the taxes due
on the interest earned until the interest is withdrawn! By postponing that tax
with a tax deferred annuity, your money compounds faster because you can earn
interest on dollars that would have otherwise been paid to the IRS. Later, if
you decide to take a monthly income, your taxes can be less because they will be
spread out over a period of years. Like CD's, annuities have a penalty for early
surrender, however most annuity contracts have a liberal "free withdrawal"
You pay NO taxes while your
money is compounding though withdrawals during the deferral period may be
taxable. You can also pay a lower tax on random withdrawals because you control
the tax year in which the withdrawals are made, and only pay taxes on the
interest withdrawn. Tax deferral gives you control over an important expense -
your taxes. Any time you control an expense, you can minimize it. The longer you
can postpone this particular expense, the greater your gain when compared to the
gain you would make with a fully taxable account.
The Tax-Deferred Advantage
To illustrate the increased
earnings capacity of tax-deferred interest, compare it to fully-taxable
earnings. $100,000 at 6.0% will earn $6,000 of interest in a year. A 30% tax
bracket means that approximately $1,800 of those earnings will be lost in taxes,
leaving only $4,200 to compound the next year. If these same earnings were
tax-deferred, the full $6,000 would be available to earn even more interest. The
longer you can postpone taxes, the greater the gain.
Safety of Principal
Your tax-deferred annuity is
safe. A qualified legal reserve life insurance company is required to meet its
contractual obligations to you. These reserves must, at all times, be equal to
the withdrawal value of your annuity policy. In addition to reserves, state law
also requires certain levels of capital and surplus to further increase
policyholder protection. Legal reserve refers to the the strict financial
requirements that must be met by an insurance company to protect the money paid
in by all policyholders. These reserves must at all times be equal to the cash
value (principal plus interest less early withdrawal fees, if any) of every
annuity policy. State insurance laws also require that a life insurance company
must maintain certain minimum levels of capital and surplus, which provide
additional policyholder protection.
No More 1099's
There is no withholding tax
while your annuity is compounding; it is completely tax-deferred. If you request
a distribution (random withdrawals or annuity income), taxes will be withheld -
unless you elect differently. Your election not to withhold can be made at the
time you make your request. Because the interest is tax-deferred, it is not
necessary to issue a Form 1099 while your money is compounding. Only when your
interest is distributed (withdrawal or annuity income) will a Form 1099 be sent,
reflecting the amount of interest actually received.
When Does My Money Mature?
An annuity policy does not
"mature" like a bond or certificate of deposit. Both your principal and interest
will automatically continue to earn interest until withdrawn or you reach age
100. You can let your money continue to grow, make withdrawals, or begin
receiving an annuity income at any time.
What is the Penalty Tax
and When Does it Apply?
An IRS penalty tax, currently
10%, may be payable on any withdrawal of interest or qualified premium made
prior to age 59 1/2.
Withdrawals from a ROTH IRA may be
subject to the 10% federal tax penalty if not held for 5 years or age
59 1/2, which ever is
If a death should occur, the
accumulating funds within your annuity may be transferred to your named
beneficiaries, avoiding the expense, delay, frustration and publicity of the
probate process. Like most assets, the annuity is part of your taxable estate.
Your heirs can chose to receive a lump sum payment, or a guaranteed monthly