Optimizing Fixed Annuity Tax Deferral

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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 products1.

I 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 I explore ways to maximize their tax-deferral benefits.

I explain the concept of the exclusion ratio and how it relates to the taxation of fixed annuities. I then provide multiple examples and the intuition that lead to a novel approach for optimizing tax-efficiency. By exploiting the manner in which the exclusion ratio is applied, I find my 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%.