What are the Uses and Limitations of Annuities?

Annuities can be useful in both the tax-qualified and non-qualified markets. The annuitant has the benefit of the investment management offered by insurers. This can be important for older persons who may desire to be freed of investment cares and management. Annuitants would enjoy monthly incomes at retirement age that are equal to or higher than those obtainable through the customary channels of conservative investment, if they are willing to have the principal liquidated and enjoy reasonably good health. Each year, the insurer would pay to the annuitant the current income on his or her investment plus a portion of the investment itself. If the buyer exercises care in the purchase decision, the net return on his or her annuity should prove competitive with investments of comparable quality. When tax benefits are considered, the net return often will exceed those of comparable savings media. Of course, with fixed-value annuities, inflation can erode the purchasing power of the annuity payments. The income is certain; the annuitant may spend it without fear of outliving it. In the absence of an annuity, the danger exists of spending too much or too little. With the annuity, the scale of spending is not only increased but is definite in amount.
Uses in Tax-Qualified Markets
Annuities are popular funding media for retirement plans. In many countries, including the United States, contributions to certain qualified personal retirement plans may be deducted from taxable income. These plans differ greatly, and it is beyond the scope of this section to analyze them. Annuities fund pension and profit-sharing plans qualified under the U.S. Internal Revenue Code (IRC) Section 401 for corporations and self-employed individuals. Annuities are also used with plans qualified under IRC Section 403(b). These plans, commonly referred to as Tax-sheltered annuity (TSA) plans, are available to employees of public educational institutions and certain tax-exempt organizations. To a specified limit, plan contributions either by the employer or by the employee, through a voluntary salary reduction agreement, are excludable from the employee’s taxable income. Employees’ rights under such plans are non-forfeitable and must be nontransferable. Withdrawals prior to age 59 are subject to a 10 percent surcharge tax in addition to full income taxation. Annuities are also used to fund public employee deferred compensation plans, which are qualified under IRC Section 457 and may be established for persons who perform services for states, political subdivisions of states, agencies or instrumentalities of states or their political subdivisions, and certain rural electric cooperatives. In the United States, for tax years after 1986, individuals not participating in employer- sponsored retirement plans and those who do participate but whose annual incomes are below certain minimum levels have been able to contribute up to $2,000 of earned compensation to an individual retirement account (IRA). Contributions are tax deductible, and interest credited to IRAs accumulates on a tax-deferred basis. Contributions to an IRA by individuals who do not meet the qualification requirements are not tax deductible, but the earnings are tax deferred. With the so-called Roth IRA, withdrawals after age 59 are completely free of income tax provided the account has been open for at least five years. Annuities can be used to fund IRAs, although such usage may make little financial sense because one is placing a tax-preference instrument in a tax-preference plan—often an unwise move. A 401(k) plan is a profit-sharing plan established by an employer under which up to three types of contributions are permitted: employer contributions, employee contributions from after-tax income, and employee salary reduction (elective) contributions. Neither employer nor elective contributions are included in the employee’s taxable income. Furthermore, the employer may deduct both of these contributions from taxable income, up to a limit. Annuities can be used as 401(k) funding vehicles.
Uses in Non-qualified Markets
Each year individuals purchase thousands of annuities unrelated to employment and not qualified under any plan for deductibility of contributions. Unlike the situation with tax-qualified retirement plans, annuity owners face no contribution limitations yet enjoy tax deferral of investment income. Besides deferring tax on investment earnings, they provide contemporary investment returns. A $1,000 per year contribution is assumed to be made to an annuity crediting 8 percent on the gross contribution (on a tax-deferred basis) and to another savings instrument earning 8 percent, but on a taxable basis. A marginal tax rate of 31 percent is assumed. The annuity fund builds to more than $122,000 in 30 years whereas the taxable fund grows to about $77,000. For a fair comparison, however, the assumption is made that the annuity value is taken as a single-sum distribution at that time, with the result that all deferred interest earnings would be subject to the 31 percent tax. (Amounts paid on a periodic basis would receive more favorable tax treatment) Even after paying almost $29,000 in taxes, the annuity purchaser would still be $17,000 ahead of the taxable investment. Even though annuity benefits do not escape taxation entirely, the fact that taxes are deferred for several years means that the contract owner—not the government—has use of the money. The effect is that the power of compounding at before-tax rates yields a significantly larger sum than would otherwise be the case. Moreover, even if that sum were subject to immediate and full taxation later, the net result remains strongly in favor of the tax-deferred instrument.