- Potential for better after-tax performance than fully taxable accounts
- No current-year taxes on investment earnings
- Simplified tax recordkeeping
Do you actively trade mutual funds or ETFs? Or do you follow a sector rotation strategy, moving in and out of sectors depending on business cycle and market trends, with a portion of your overall well-diversified portfolio? 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 make tactical trades in tax-deferred accounts, such as workplace savings plans, IRAs, and tax-deferred variable annuities. Tax-deferred variable annuities often are overlooked but, for investors who have maximized contributions to workplace savings plans and IRAs, they are an option worth considering.
With a tax-deferred variable annuity, gains on trades are taxed at withdrawal, enabling deferred growth potential.* Also, unlike retirement accounts, annuities have no contribution limits, a plus for higher-income investors. And annuities don't have required minimum distributions (RMDs), with many annuities allowing tax-deferred investing until age 90 or later.
And for those who engage in active trading, doing so inside a tax-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, a vice president and actuary at Fidelity Investments Life Insurance Company.
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 higher-net-worth, active investors, the tradeoffs may be worth it. Says Tom Ewanich, "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."
One approach to frequent trading: Sector rotation strategy
The business cycle has 4 phases that reflect fluctuations in the US economy, and each phase may have an effect on sector performance. Historically, some sectors tend to perform better or worse than others in certain phases. Monitoring the business cycle may help you determine which sectors you should focus your investing on during each phase.
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 $622,050 in 2020, for example, would owe 37% 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 $40,001 and $441,450, and at 20% for those with income above that amount. For married couples filing jointly, the 15% range is $80,001 to $496,600, 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 variable 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 variable annuity can be particularly attractive.
Making a decision
If you have a longer time horizon, have already reached the maximum contribution limits in your 401(k) or IRA, and/or your investment approach lines up with the annuity's key advantages, a tax-deferred variable annuity may be suitable for you—particularly if you are thinking about a sector rotation investment strategy. Be sure to consult an investment professional as you develop your plan.
Next steps to consider
Make an appointment to talk to a Fidelity advisor.
Consider these options for your sector rotation strategy.
Increase your tax-deferred savings and customize your investment approach for your goals.