3 key takeaways
✔ Potential for better after-tax performance than fully taxable accounts
✔ No current-year taxes on investment earnings
✔ Simplified tax recordkeeping
Do you follow a sector rotation strategy with a portion of your overall well-diversified portfolio, moving in and out of sectors depending on business cycle and market trends? Or do you actively trade mutual funds or ETFs? If so, you might generate considerable short-term capital gains, which are taxed annually at high ordinary income tax rates. For investors in higher tax brackets, the impact to returns can be significant.
The good news is that there are ways to help reduce the tax bill. One strategy would be to trade in tax-deferred retirement accounts. But many investors believe—and we generally agree—it’s better to keep retirement accounts invested strategically for the long term. If that’s your preference, making tactical trades within a tax-deferred variable annuity* could be an option worth considering. Read more about tax-deferred variable annuities and asset location in Viewpoints: “Why asset location matters.”
With a variable annuity, gains on trades are not taxed until withdrawn.* Also, unlike retirement accounts, annuities do not have contribution limits, a plus for higher-income investors. Nor do annuities have required minimum distributions (RMDs), and many annuities allow tax-deferred investing until age 90 or later. Of course, there are caveats. Annuities can sometimes carry heavy fees, so you will want to shop for a low-cost product from a reputable provider. You may also sacrifice some liquidity because withdrawals of earnings before age 59½ are penalized. Investment choices may be limited. And in contrast to a taxable brokerage account, with an annuity you lose the opportunity to offset tax losses against gains or capture lower capital gains rates on withdrawals of long-term gains.
Still, for some older, higher-net-worth, active investors, the tradeoffs may be worth it. Says Tom Ewanich, a vice president and actuary at Fidelity Investments Life Insurance Company, “For an investor with a time horizon of 10 years or more, a tax-deferred variable annuity is worth looking into. Most people don’t like paying more taxes than they have to, and the ability to control your distributions and potentially manage your tax bracket can be very attractive.”
How much more can you keep?
Gains on investments held a year or less in fully taxable accounts are taxed at the investor’s marginal income tax rate, which is typically much higher than the long-term capital gains tax rate. Married couples filing jointly with taxable income of more than $470,700 in 2017, for example, would owe 39.6% federal tax on short-term capital gains, and even more if they’re subject to the 3.8% Medicare surcharge on investment income. In addition, state and local taxes could raise the total.
Long-term capital gains, on the other hand, are taxed at 15% for single taxpayers with taxable income between $37,950 and $418,400, and at 20% for those with income above that amount. For married couples filing jointly, the 15% range is $75,900 to $470,700, and the rate is 20% above that level. Long-term capital gains rates increase to 18.8% and 23.8% for taxpayers subject to the Medicare surcharge. And, again, state and local taxes can also raise the total rate.
Although earnings withdrawn from a tax-deferred annuity are taxed as ordinary income—the same as short-term capital gains—the effect of tax-deferred compound earnings over time is what can give a low-cost annuity an advantage over a fully taxable account for investors who trade frequently.
Plus, many people may drop into a lower tax bracket when they retire, further strengthening the case for paying taxes later rather than sooner. So for those who expect a drop in their income tax bracket as a result of lower taxable income, expect to move to a state with lower income taxes, or think that their tax rates will drop for any other reason after retirement, the use of a tax-deferred annuity can be particularly attractive.
For those who engage in active trading, doing so inside a deferred variable annuity can simplify an investor’s life in other ways as well. In addition to no longer having to worry about paying the current-year tax liability from trades, you won’t have to handle the tax recordkeeping and filing chore that goes with it. “You can focus on investing and adapting without considering tax implications,” says Tom Ewanich.
An important consideration when looking into a variable annuity as an investment vehicle is fees. A high-fee annuity can reduce the tax advantages, but the good news is that investors can now find annuities that keep costs low by removing special features, such as a guaranteed death benefit, that were once common in annuity products.
Additionally, when you have investments inside a deferred variable annuity that are at a loss, you won’t be able to “harvest” tax losses and use them to offset gains of $3,000 a year in ordinary income. Investment returns from a deferred variable annuity will not be taxed until you make a withdrawal, but the gains will be taxed at your ordinary income tax rate. That includes long-term capital gains, which, had they been generated in a taxable account, might have been taxed at the lower long-term capital gains rate.
The benefit of deferral may not be sufficient to offset the disadvantage of being taxed at a higher rate. For this reason, it’s important to give the assets sufficient time to grow tax deferred, 10 years or more as a general rule of thumb.
So, it’s best to give preference within the annuity to assets that generate investment income that would be taxed at ordinary income tax rates, or assets that are frequently traded or turned over and thus tend to generate short-term capital gains, rather than those that mostly tend to generate long-term capital gains.
Another consideration is liquidity. Assets in taxable accounts are generally accessible at any time, but annuities come with penalties for withdrawing earnings before age 59½. Because of this, it is best suited for those who don’t intend to use those assets before that age, or for those who are already at least 59½.
Finally, the available investment options within annuities are typically limited compared with those in taxable accounts, where you will usually find the widest array of investment options to choose from. If you pursue an annuity, try to find one that is low cost and offers options across all asset classes in which you will need to build your portfolio.
Making a decision
If you have a shorter time horizon, have not already reached the maximum contribution limits in your 401(k) or IRA, and/or your investment approach does not line up with the annuity's key advantages, a tax-deferred annuity may not be the solution for you. Be sure to consult an investment professional as you develop your plan.