Fixed Index Annuities – Compounding Tax Deferral Explained
One of the features of a Fixed Index Annuity (FIA) is that it grows tax deferred on a compounding basis. Essentially what this means is that your interest earned every year is not taxed but is left in the annuity to continue to grow each year and is only taxed when taken as income at some point in the future.
This can be more significant than one would, at first, imagine.
Let us take a simple example to illustrate the point. Let us assume that one has an initial investment of $100,000 of after-tax money, and it grows at 5% pa inside an annuity for 10 years.
At the end of year 1, the investment would be $105,000 and this would remain intact for growth in year 2 which would be 5% on the new capital balance of $105,000. So at the end of year 2, you would have $110,250. At the end of year 3, it would be $115,763 and so on, until at the end of year 10, the capital amount would be $162,890. Not too shabby!!
Now, let us assume a tax rate of 30% and see where we would be every year if we had to pay the tax each year. At the end of year 1, you would have $105,000 less 30% of the growth of $5,000 i.e. $1,500, a net figure of $103,500. At the end of year 2 this net figure would be $107,123, and at the end of year 3 it is $110,872. Suddenly we see that the gap is widening because of the effect that compound interest has on the additional growth every year.
And, at the end of year 10, the taxed growth example would realize a net figure of $141,060. This against an untaxed figure of $162,890! This is a difference of $21,830 or nearly 15.5% more. And all this for giving up 30% of a 5% growth each year, i.e. 1.5% each year!
Further assume that, at the end of year 10, one took the entire principal amount of $162,890 as income, and paid tax on the growth of $62,890 at the same tax rate of 30%. This would mean paying tax of $18,867. If we then deduct this from the additional growth of $21,830, one is left with an after tax benefit of $2,963. And all thanks to Uncle Sam allowing you to keep his share to grow within your investment! Contrast this with mutual funds etc. where you have to pay tax on the growth every year.
All this is over 10 years. If one did the numbers over more years or increased the rate of return, the difference would be even more dramatic because of the Power of Compound Interest!
So the next time you hear about one of the benefits of FIAs being deferred taxation, treat this feature with the due respect that it deserves!
To learn more from this educator, click here (Anton Hendler).
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