The hidden power of tax-deferred growth: Understanding annuity tax benefits

As retirement gets closer, many people begin asking a familiar question: How do I protect what I’ve saved? The answer often leads to choosing more conservative options like CDs, bonds and money market accounts to supplement their qualified retirement savings. While these products are designed to provide financial stability and can be a valuable part of an overall portfolio, annual taxes may reduce a portion of your long-term retirement income potential.

By adding an annuity to your retirement income plan, you can create a predictable source of income in retirement while deferring taxes on growth during your highest-earning years. For many pre-retirees, a more tax-efficient strategy can increase the income available throughout retirement.

Tax advantages of an annuity

When you keep your money in savings accounts like CDs or money markets, you pay taxes every year on the interest you earn. Annuities, on the other hand, may offer certain tax advantages:

1. Tax-deferred growth: Your money compounds without paying annual taxes on interest earned until withdrawals are taken.
2. Tax bracket flexibility later: You may be taxed at a lower rate after you retire.

An annuity allows you to accumulate savings for future income while deferring taxes on gains until later, potentially when your tax rate is lower. Instead of paying taxes on a portion of your growth each year, more of your money is allowed to compound – helping support your future income needs.

How an annuity can support long-term growth through tax-deferred accumulation

To better understand the benefits of an annuity’s tax-deferred growth, let’s look at a hypothetical example. Susan is 55 years old, with a plan to retire and start drawing income once she turns 65. Her tax bracket before retirement is 32% and is expected to decrease to 25% once she stops working. She has $100,000 to put toward retirement income and is considering either a money market account or an annuity.

In year one, both accounts could earn $5,000 in interest, but she would have to pay $1,600 in taxes on her money market account.

Each year, as she keeps more of her gains, the tax-deferred interest compounds.

Later, when she retires at age 65 and her taxable income drops, the growth in her annuity will be taxed at 25% instead of 32%. That seven-percentage-point difference applies to every dollar of growth accumulated over the past 10 years. By deferring taxes during peak earning years and withdrawing in retirement at a lower rate, she is able to keep more of what she’s earned.

Using an annuity to create lifetime income for retirement

After meeting with a financial professional, Susan decides to use the full $200,000 to purchase a fixed annuity with a guaranteed lifetime withdrawal benefit (GLWB). In addition to growing her savings on a tax-deferred basis, she can create a predictable $28,800 annual income stream starting at age 65 that can last for the rest of her life.

Trying to match that same annual income using a money market account could lead to her running out of savings by age 79, even when she has an 85% chance of living a longer life.¹ 

This table compares after-tax income at age 65 from $200,000 savings invested at age 55 earning 5% interest to lifetime income from an annuity.

By combining the tax benefits of an annuity with income that can last for life, Susan created a retirement income strategy designed to help support her expenses throughout retirement.

Getting guidance to build your retirement plan

Along with growing your savings, a successful retirement strategy should help turn those savings into reliable income that can support your future goals and the life you want to live. Talking to a financial professional can be helpful as you explore your options, navigate tax planning strategies and determine if an annuity is right for you.

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¹ 2012 Society of Actuaries Individual Annuity Mortality Table adjusted for 0.8% annual mortality improvement through 2024.

Any information regarding taxation contained herein is based on our understanding of current tax law, which is subject to change and differing interpretations. This information should not be relied on as tax, legal or financial advice and cannot be used by any taxpayer for the purposes of avoiding penalties under the Internal Revenue Code. We recommend that taxpayers consult with their tax or legal professionals for applicability to their personal circumstances.