Research Articles

Optimizing Fixed Annuity Tax Deferral

The following is an abstract. Here is a link to the full article: Optimizing Fixed Annuity Tax Deferral.
DISCLAIMER: This article discusses topics at the nexus of investments, annuities, and taxes. This article does not provide and should not be construed as providing tax advice. In order to assess tax benefits specific to annuities, we assume they are held in taxable (non-qualified) accounts unless otherwise specified.

Annuities are popular tools for retirement income planning. While stigmas exist around some annuity products (for good reason), recent research shows how fixed annuities can add value in the context of retirement income. In addition to being able to guarantee income for life, tax benefits are often advertised as a key advantage of using annuities. This article discusses the mechanics of tax deferral in annuity products[1].

We first consider variable and indexed annuities and how the value stemming from their tax deferral can be diluted or even negated due to the growth eventually being taxed as income rather than capital gains. For fixed annuities, this is less a concern as bond interest is already taxed as income. So we explore ways to maximize their tax deferral benefits.

We explain the concept of the exclusion ratio and how it relates to the taxation of fixed annuities. We then provide multiple examples and intuition that lead to a novel approach for optimizing tax-efficiency. By exploiting the manner in which the exclusion ratio is applied, we find our approach allows us to reduce taxes by as much as 12% relative to standard fixed income investments for investors with a marginal tax rate of 25%.


[1] While this article highlights annuity strategies to maximize the tax efficiency, one must consider the bigger picture including price paid and value delivered. As we highlight multiple times within the article, taxes are just one consideration.