Tax-Deferred Compounding
The interest you earn on an annuity compounds each year – your investment earns interest and that interest is reinvested, so you earn interest on your interest. Because the payment of income taxes on annuity income is deferred until you make a withdrawal, your investment grows much faster than a comparable investment subject to annual taxation.
Example Showing the Benefit of Tax-Deferred Compounding
This example illustrates the benefit of investing in an annuity, which has tax-deferred compounding, compared to an alternative investment without tax-deferred compounding, such as a CD.
Assumptions Used in this Example
- Initial investment of $10,000.
- Investment period of 10 years.
- Annual interest rate of 5%.
- The investor's marginal income tax rate is 33%.
Results for Annuity Investment
|
Interest Earned |
Income Taxes Paid |
Investment Balance |
Initial Investment |
- |
- |
$10,000.00 |
Year 1 |
$500.00 |
- |
$10,500.00 |
Year 2 |
$525.00 |
- |
$11,025.00 |
Year 3 |
$551.25 |
- |
$11,576.25 |
Year 4 |
$578.81 |
- |
$12,155.06 |
Year 5 |
$607.75 |
- |
$12,762.81 |
Year 6 |
$638.14 |
- |
$13,400.95 |
Year 7 |
$670.05 |
- |
$14,071.00 |
Year 8 |
$703.55 |
- |
$14,774.55 |
Year 9 |
$738.73 |
- |
$15,513.28 |
Year 10 |
$775.66 |
- |
$16,288.94 |
Withdraw Funds |
- |
$2,075.35 |
$14,213.59 |
Total |
$6,288.94 |
$2,075.35 |
$14,213.59 |
Results for Alternative Investment Without Tax Deferral
|
Interest Earned |
Income Taxes Paid |
Investment Balance |
Initial Investment |
- |
- |
$10,000.00 |
Year 1 |
$500.00 |
$165.00 |
$10,335.00 |
Year 2 |
$516.75 |
$170.53 |
$10,681.22 |
Year 3 |
$534.06 |
$176.24 |
$11,039.04 |
Year 4 |
$551.95 |
$182.14 |
$11,408.85 |
Year 5 |
$570.44 |
$188.25 |
$11,791.04 |
Year 6 |
$589.55 |
$194.55 |
$12,186.04 |
Year 7 |
$609.30 |
$201.07 |
$12,594.27 |
Year 8 |
$629.71 |
$207.80 |
$13,016.18 |
Year 9 |
$650.81 |
$214.77 |
$13,452.22 |
Year 10 |
$672.61 |
$221.96 |
$13,902.87 |
Withdraw Funds |
- |
- |
$13,902.87 |
Total |
$5,825.18 |
$1,922.31 |
$13,902.87 |
This example clearly shows that the tax-deferred annuity investment produces a much more favorable return for the investor.
The tax-deferred benefit of investing in an annuity is even greater if a 1035 exchange is utilized. See an example showing the increased benefit from a 1035 exchange.
July 30, 2010
Types of Annuities
Frequently Asked Questions
Examples
