Is your client’s money working as hard as it could be?
Individual investors may be looking maximize their investments by utilizing a tax-efficient strategy. One feature annuities, such as Multi-Year Guaranteed Annuities, and Fixed Index Annuities, offer is tax deferral. Using this feature, the annuity owner can take a larger percentage gain and defer taxes on a larger lump sum down the line. Pay the taxes on the principal and defer taxes on the gains.
The concept of tax deferral can be demonstrated by doing some simple math, specifically using the Rule of 72 on a tax deferred investment, and a taxable investment.
The Rule of 72 starts by dividing 72 by the annual return rounded up to the whole number, the result is approximately how long it takes to double your money using compounding interest.
In this scenario we assume a 6% return. In this instance a 6% return doubles every 12 years.
The Rule of 72 using a 6% Return
Looking at $100,000 invested growing with and without taxes we find the true impact taxes have on investments.
First, we run through a taxable investment. For numbers sake, we take out 2% (33% tax rate) in taxes annually dragging returns down to 4%.
A 4% return doubles every 18 years and ends with $400,000.
Looking at tax-deferred, we assume a 6% annual tax growth, deferring taxes till later.
At the end of the term, we see the account value being $800,000.
How much in taxes do you pay with a lump sum withdrawal in this scenario?
One account ends with $400,000 and the other ending with $800,000, which the tax deferred investment has not had taxes paid on it quite yet. Using a 33% tax bracket, the individual would pay $231,000 in taxes. This is found by the following formula, $800,000(final value)-$100,000 (original investment amount, taxes already paid on this amount) = $700,000(Taxable Amount) * 33% (Tax Rate) = $231,000 Taxes. Simply by deferring taxes, this individual uses the same return to gain over $169,000 more over the same period.
If the investor wants to turn their investment into an income stream, they would receive $8,450 more annually through tax deferral.
Three things to consider when looking at tax deferred investments:
Interest on principal: How much interest can you get in a principally protected investment, whether it is tax deferred or taxable?
Interest on interest: How much interest are you receiving through these investments?
Interest on money you would otherwise pay in taxes: How efficiently are you structuring your investments to maximize returns?
Download our taxable yield chart to show what a taxable investment would need to yield to equal the same yield on a tax deferred account.
Reach out to us if you have any questions on tax efficient investing or any other retirement planning needs, we are happy to help.
This material is intended for educational purposes only and is not intended to serve as the basis for any investment or purchasing decisions.
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