The Pros & Cons of Tax-Deferred Annuities

People looking for long-term tax-deferred investment opportunities may find annuities appealing. If you have reached your maximum IRA contribution limits or do not have access to a 401(k) through employment, deferred annuities can become your next choice for accumulating retirement funds in a savings vehicle that provides tax advantages. Knowing the pros and cons of such an option can help you decide if tax-deferred annuities are the right long-term investment vehicle for you.

Although traditional IRAs and 401(k) plans can be funded with pretax dollars and allow for tax-deferred growth of investment earnings, contributions are limited. Contributions to tax-deferred annuities are made with after-tax dollars and there are no restrictions on the amount you may deposit.

Investment earnings within the deferred annuity are not taxable until you make withdrawals. That means the full amount of your investment growth is compounding and producing returns. The impact on a long-term investment can be significant. If you invested $1,000 per year from age 35 to age 65 and earned an average rate of return of 6 percent, your tax-deferred accumulated value would be $83,801.68. Those same funds in a taxable investment, assuming you were in a 30 percent tax bracket, would amount to only $60,431.76.

Tax-deferred annuities are savings contracts issued by insurance companies and carry certain safeguards against market losses. Some annuities that allow you to invest your contributions in investment funds tied to the performance of stocks and bonds carry a guarantee that your investment losses will be minimized when markets go down.

Annuity contracts typically carry high fees to cover the costs of agent commissions, administration fees, investment charges and guarantees. Some annuities can come with annual fees as high as 3 to 4 percent and may erode the tax-deferral advantage.

Annuities can come with an early withdrawal penalty anywhere from the first seven to 15 years of the contract. This may cause some problems for older investors or people looking for emergency funds. Keep in mind that annuities are long-term investment contracts and if one of your main needs is access to funds in the short term, consider contributing a portion of your savings to more liquid investments such as money market funds or short-duration certificates of deposit.

When you make withdrawals, your tax-deferred investment earnings are taxed at ordinary income rates. This includes all of your investment earnings even if they originated from capital gains from mutual fund investments. This can be a disadvantage since capital gains are generally taxed at lower rates than ordinary income is.

When you make a withdrawal, it is assumed that investment earnings are withdrawn first and therefore all income from your annuity is taxable until all investment earnings are deemed withdrawn. Furthermore, if you make a withdrawal before you reach the age of 59 1/2, your withdrawal will be subject to a penalty tax of 10 percent in addition to any regular tax payable on the withdrawal.