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2001-07-01 16:07:00

How much difference does it really make whether an investment is tax-deferred or taxable?

Question:  How much difference does it really make whether you have a tax-deferred investment or one that is taxable?

Answer:  It can be substantial.  If you are not paying taxes on earnings on an annual basis, you get the benefit of earnings on these taxes plus the earnings on your principal... year after year after year.  The compounding effect of this can be considerable  over a long period of time.Let’s take for example a deposit of $100,000 put into a Certificate of Deposit at a financial institution.  This type of investment is taxable on an annual basis.  Let us also figure a 6% rate.  While you may or may not take the earnings on the CD, you will be taxed on these earnings each year.  At the end of each year, you will receive a 1099 for which you will pay taxes on these earnings as ordinary income.  The analysis in Table 1 at right indicates the performance over a 30 year period of time.  What may even be more interesting is what if the rate on your taxable investment is yielding only 4%?  By the time you take out a 3.5% inflation factor, and taxes of 1%, you end up with a negative .05% return.  That’s not good. The analysis in Table 2 illustrates the same $100,000 deposited in a tax-deferred investment, such as a whole life policy, an annuity, an IRA, a 401K, etc.  You can see that at the end of 30 years, the difference is almost $250,000.  The difference at any year short of the 30 years can be seen by comparing the ‘Balance After Taxes’ columns.  Most probably you will pay taxes when you take out the money from a tax-deferred investment.  It depends on the type of investment.  In a whole life policy, it is possible that taxes can be avoided altogether with the proper structuring.  Even if taxes are higher at the time you pull out the money from a tax-deferred investment, you still will be well ahead due to this compounding of earnings.  Question:  Can you tell me how a fixed annuity works?Answer:  One of the most popular investments today, following what we have experienced in the market over the last year to year and a half, is the fixed annuity, or what is known as a ‘certificate of annuity’.  A fixed annuity is a contract between you and an insurance company whereby the insurance company contracts with you to use your money and pay you a guaranteed interest rate for a period of time which grows tax-deferred.  There are seldom any management fees attached to an annuity so all of your money is ‘working’.  In return for the guaranteed interest rate and the tax-deferral benefit, the company imposes certain restrictions on the contract, much the same as a certificate of deposit with a financial institution.  The annuity contract has what is called a ‘surrender period’.  A surrender period is the period of time that de-escalating penalties apply if you take out your money.  For instance, a typical surrender period might be 7 years, where a 7% penalty is imposed on the balance of the annuity if you take out your money during year 1.  A 6% penalty is imposed on the balance if you take out your money during year 2.  A 5% penalty during year 3; a 4% penalty during year 4; a 3% penalty during year 5; a 2% penalty during year 6; a 1% penalty during year 7; and no penalty if taken out after year 7.  This is similar to the penalties imposed on a certificate of deposit for early withdrawal.  The certificate of annuity does however have several advantages.  First is the tax-deferral benefit explained above.Second, the typical certificate of annuity has a feature which allows you to take out up to 10% of the balance during any year with no penalties whatsoever.  You can take out 10% of the balance every year if you choose... again with no penalties.Third, the interest rate is guaranteed for the period of time stated in the contract, just like a certificate of deposit, only with the compounding effect of the tax-deferred benefit.  This makes for a good comparison between a certificate of annuity and a mutual fund.  Again, not only is the mutual fund taxable on an annual basis, but the market risk factor makes it unappealing to many.  As you can see from Table 3, the earnings shown for the mutual fund are very typical of some of the best performing funds over the last 10 years (excluding the last year or two when many of the best funds lost 30% or more in value).  Who would ever believe the balance at the end of 10 years is the same?  Of course as you already know, it is not the same because taxes were not considered in either case.  This would mean that the certificate of annuity would be 17.32% better off than the mutual fund (check ‘Balance after Taxes’ in Tables 1 & 2 above at the end of 10 years)... again with no market risk.Question:  Is a certificate of annuity as safe as a certificate of deposit?Answer:  As a matter of fact, it might surprise you to  know a certificate of annuity is at least as safe as a certificate of deposit, and probably even more safe.  You see, the FDIC (Federal Deposit Insurance Commission) is the entity that guarantees a certificate of deposit, in all institutions that are members.  The FDIC purchases re-insurance to help manage its risk.  Who do you suppose the FDIC purchases reinsurance from?  That’s right... the very same insurance companies who offer annuities.  Further, all insurance companies that do business in the state of Kansas must pay into the State Guarantee Fund.  This is a fund that co-guarantees amounts in certain insurance products.  In some life insurance products, the guarantee is the same limit guaranteed by the FDIC on certificates of deposit... $100,000.  Included in this list of life insurance products are such things as cash values in life insurance policies... and certificates of annuity, both up to $100,000.  Question:  What are the down sides to a fixed annuity?Answer:  The biggest downside comes if you purchase an annuity where the guarantee period does not match the surrender period.  For instance, suppose you purchase a certificate of annuity where it guarantees a 6% interest rate for 3 years, but the surrender period is 10 years.  After the 3 years, the insurance company could drop the guaranteed rate to the minimum contract rate guaranteed in the certificate of annuity contract... that of say 3.5%.  If you did not like this and wanted to withdraw your money, you would have to pay the surrender charges in the contract... probably 6 or 7%... which could be equal to or more than one year’s guaranteed interest rate.   Another downside could be if the certificate of annuity imposed the surrender charge at death.  Question:  Is a fixed annuity still then one of the best possible savings protection and maximization plans available today?  Answer:  Yes, if you will make sure of the following 5 things:1.  The insurance company is rated ‘A’ or above by the major rating companies (AM Best, Duff & Phelps, Standard & Poors, Moody, etc.).2.  That the guaranteed rate is competitive to not only the rates on certificates of deposit, but also competitive to other certificates of annuity from other insurance companies.3. There is no surrender charge imposed at death.4.  That you can withdraw up to 10% of the balance in any one year, or every year, with no penalty whatsoever.  5. Most important... make sure the guarantee period matches the surrender period.  If the guaranteed rate is for 5 years, the surrender period needs to be 5 years.  So, if at the end of the guaranteed interest period the insurance company wants to drop the guaranteed interest rate on the contract to its minimum, you can get all of your money and buy another certificate of annuity, or move to another investment,  with no penalty whatsoever.It is unfortunate that in the past some sellers of annuities thought of their own interests before they they thought of their clients’ interests... and didn’t check the five items mentioned above.  As a result, some buyers of annuities have been disenchanted with the annuities they have purchased.  Again, it is most always because one or more of the 5 criteria listed above was not met.  Usually the biggest reason is that the guarantee period is considerably shorter than the surrender period.  The owner of the certificate of annuity is happy throughout the guarantee period, but when that period is over and the guaranteed interest rate drops, he or she has no choice but to stick with the annuity at the lower rate, or to incur the surrender charge and move to another investment. The properly structured fixed certificate of annuity is quickly becoming an ideal investment vehicle for many people after experiencing the tumultuous market over the last year and a half to two years.  Unlike life and health insurance, you do not have to be underwritten to purchase an annuity.  The application process is quick and painless.  Is a Certificate of Annuity for you?  It might pay to check it out.