In my recent travels through the world of retirement income planning, it seems to me that many industry participants have forgotten two important facts about the current economic environment.
First, a substantial demographic segment of the U.S. population is still very much in accumulation mode and quite far from retirement income needs, especially after last year's stock market setback.
Second, as the U.S. emerges from the Great Recession, a $1.6 trillion (and growing) deficit will eventually have to be financed with higher income taxes. In other words, given the proportion of the population still accumulating funds for retirement and the likelihood of increased tax burdens on the middle and upper class, I think the economic value of tax deferral is being overlooked by many annuity manufacturers, marketers and distributors.
Accordingly, in this column I would like to go "back to basics" and examine the technical benefits of pure tax deferral in the accumulation phase of retirement planning, independently of the guarantees and lifetime benefits applicable in the income stage.
There are obviously many ways — and assumptions you can make — to analyze the tax benefits (or costs) of annuities. My preferred approach is to start by making the smallest number of assumptions and keep things as easy as possible for as long as possible to develop a strong intuition. Indeed, when explaining this to individual clients, the motto should be: simplicity first, then accuracy.
So, here's my starting point: Assume that you invest $100 in a generic "portfolio" and you plan to hold this investment for a long time. The core investment can be a mutual fund, sub-account, managed account, ETF, etc, which sits inside a particular tax structure.
The table on the following page illustrates the consumable value of this investment under three generic income tax structures. The three are (#1) no-tax-ever, (#2) higher-rate, but tax-deferred, and (#3) lower-rate, continuously-taxed.
Think of the first as a (universal) life insurance policy in which the death benefit is tax-free, the second is an annuity in which gains are tax deferred but then taxed at the ordinary income rate upon (live) withdrawal, and the third is a taxable account in which capital gains are taxed on an annual basis. Yes, I am playing a bit loose here, but bear with me. Remember, simplicity first.
Finally, for the actual numbers, assume that (federal) taxes on ordinary income is 35 percent, and (federal) taxes on capital gains is 20 percent, which is a conservative forecast of where the current (historically low) 15 percent rate is soon headed. I'll ignore state and local taxes, to keep things simple. (Or, assume you live in my favorite states, Texas or Wyoming.)
Here's how to read and interpret the table. The second, third and fourth columns display after-tax (consumable) values for your $100 initial investment under the three structures, assuming the underlying portfolio earns 7.29 percent after-fees pre-tax each year. (Later I'll explain why I selected a return of exactly 7.29 percent, but for now think of it as the long-term after-fee return from a generically diversified portfolio.)
And here's how the three structures play out:
o In the no-tax-ever structure, the entire gain escapes taxation. So, the pre-tax value and the after-tax value are equal at every point along the investing time horizon. In 10 years, your initial $100 investment grows to approximately $202, and after 30 years it grows to $826. This is easily verified by multiplying $100 times the (1.0729) return factor (my 7.29% return) to the power of the number of years. Generally speaking, it can be expressed algebraically as (1+R)^N, where N is the number of years and R is the investment return.
o In the high-rate, tax-deferred structure, your gains are tax-deferred while the money is invested, but once you cash in or withdraw the funds you pay (relatively high) income taxes on all gains at the rate of 35 percent. This leads to after-tax account values of approximately $166 in year 10 and $572 in year 30. The algebra is: (1-Tx)(1+R)^N+Tx, where Tx is now the 35 percent tax rate.
