Annuities versus Systematic Withdrawals: Understanding Tax Effects

Given the complexity of most annuities, analysis of them typically only considers pre-tax results.  But taxes matter. As we will see, tax impacts vary by the specific type of annuity you’re considering, and will make the difference between annuities being cost effective or a drain on cash flow.

Over the past six months, Wade Pfau and I have published articles in Advisor Perspectives on various types of annuities.1 In part, those articles have compared annuities to systematic withdrawals, with results shown pre-tax. But for non-qualified (or taxable) accounts, the tax rules for annuities and systematic withdrawals differ, so let’s look at some examples to show the tax effects.

The easy case: qualified accounts

Before dealing with non-qualified accounts, I'll first discuss the simpler case of qualified accounts. For 401(k)s, traditional IRAs and other tax-deferred retirement accounts, funds withdrawn are taxed at ordinary income tax rates, whether the funds come from annuities or regular investments. For stock investments, it doesn't matter whether the withdrawals come from invested principal, dividends or capital gains. If we have an annuity strategy and a systematic withdrawal strategy that have the same before-tax cash flows, they will have the same after-tax cash flows.

It is still important, however, to incorporate taxes when doing financial projections for clients. For example, a 25% tax rate can turn a "safe" withdrawal rate of 4% before tax into just 3% after tax. This applies whether the funds are coming from annuities or regular investments.

For qualified plans involving Roth IRAs or Roth 401(k)s, the comparisons are even simpler, because the before-tax cash flows equal the after-tax cash flows.

For individual client situations, a number of special considerations may come into play when determining optimal timing of withdrawals from qualified accounts. Tax-bracket effects, expectations about future tax rates, and coordination with Social Security-claiming strategy are among these. When considering such strategies, just remember that taxes are the same for annuities and regular investments.

Getting more complicated: non-qualified accounts

When we move to the realm of funds held in non-qualified accounts, more complex tax rules apply. For annuities, investors incur taxes when they receive funds. For investments other than annuities (such as those used to fund a systematic withdrawal plan), taxes are based on the interest, dividends and realized capital gains as they are accrue, so taxes apply even if no funds are being withdrawn. Annuities enjoy the benefit of tax deferral, but, on the other hand, investments in stocks (or stock funds) benefit from lower tax rates that apply to dividends and long-term capital gains.

When investors receive annuity payments, there are special rules to determine what portion of each payment represents taxable earnings, with the remainder treated as non-taxable return of principal. I'll get into the details as I discuss particular types of annuities.