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How to Use Insurance Products for Tax-Sheltered Growth

Life insurance and annuities can provide tax-advantaged investment returns. Learn how to house almost any type of an investment in an "annuity wrapper."

Annuities are often viewed as a way to manage the risk of longevity, of outliving your money.

But insurance products such as annuities have other benefits. Such products can provide tax-advantaged investment returns, says Michael Finke, professor of wealth management and Frank M. Engle Chair of Economic Security Research at the American College of Financial Services and a research fellow at the Alliance for Lifetime Income.

In an interview with Retirement Daily, Finke noted that insurance products are, in essence, a wrapper around different types of investments. And there are two primary types of insurance products that wrap investments: life insurance and annuities.

And annuities, he said, are the simplest form of an insurance wrapper. “You can essentially house [an investment] within an annuity wrapper and be subject to a different set of taxes than if you held that investment outside of the annuity in a fully taxable account,” said Finke, who recently spoke about this topic at the AICPA’s annual conference.

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What’s more, you can house most any type of an investment in the annuity wrapper from CDs and money markets to risky assets such as stocks, said Finke.

The Benefits of an Annuity Wrapper

According to Finke, there are three reasons why an annuity wrapper can be a more efficient way to hold investments, and especially bond-like investments, than a taxable account.

You're Not Taxed on Growth Every Year

One, you’re not taxed on the growth of your investment every year.

For instance, the interest income from a CD held in a taxable account is taxed as ordinary income each year. There’s no tax-deferred growth. In effect, bond-like investments held in a taxable account are, what Finke described, as tax-disadvantaged.

But when an investor purchases a multi-year guaranteed annuity (MYGA), an alternative to a CD, the interest income is not taxed as ordinary income each year. Instead, it grows tax-free.

What’s more, the investment in an annuity grows even more than it would in a taxable account. If you had $100,000 earning 2% a year in an annuity, it becomes $102,000 at the end of the first year,  which becomes $104,040 at the end of year two. “So, you're getting a deferral compounding bonus in your investments,” Finke said.

And that would not be the case if one held a bond or CD in a taxable account. You’d be paying taxes on the $2,000 in interest income in year one and your net after taxes might be $1,200.

Given that, annuities can work well for pre-retirees who don't need current income but want what are often conflicting investment objectives: safety of principal and growth.

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Differential Marginal Tax Rates

Something called differential marginal tax rates is yet another reason to consider purchasing an annuity. In essence, by owning an annuity, it’s possible you’ll be taxed on the distributions at a lower tax rate in retirement than if you owned a similar investment in a taxable account during your working years. 

“And that, I think, is especially for a near-retiree something to consider,” Finke said. For example, if an investor has a 30% tax rate before retirement and a 20% tax rate after retirement, they can avoid paying the higher tax rate on growth and instead pay only 20% tax on gains when the annuity is liquidated.

Annuitization and the Exclusion Ratio

An annuity is a wrapper to hold investments. But you can also choose to “annuitize” your savings. What’s annuitization? “That means you can buy lifetime income from that savings,” said Finke.

And that lifetime income comes with an additional tax deferral benefit because of something called the exclusion ratio. In essence, that ratio is used to determine what portion of your lifetime income payment qualifies as a tax-free return of principal and what portion is taxed as ordinary income.

And because of the exclusion ratio, “you can actually defer taxation for an extended period of time, up to your expected lifespan, or at least what the IRS expects your lifespan to be,” said Finke. “So that's an additional tax deferral benefit.”

Of note, Finke and a colleague recently published a study showing that people who had a lifetime income asset consistently spent significantly more than those who have the money simply in investments.

The reason? “If you have investments, you may be reticent about spending the money down because you're fearful that it might run out,” he said. “So having that lifetime income guarantee can actually give people a license to spend, to actually live better.”

What to Consider

What should you consider if you’re thinking about putting your money in an annuity? 

“If the goal is to fund income in retirement… then pay a lot of attention to things like asset location,” said Finke. “If you're investing in an IRA, then your goal is to generate as much income as possible. And one of the biggest advantages of annuities within an IRA is that they protect you against the possibility of outliving savings.”

Second, think about where to locate your assets. “This is related to a concept that's known as basis assets,” said Finke. “Basis assets are any type of an asset where you were only taxed on the gain above what you paid for. Insurance products are a special type of basis assets.”

An ETF, for instance, is only taxed at the capital gains rate. “So those can be very attractive when held within a taxable account,” he said. With an insurance product, you're going to be taxed at your ordinary income rate, which can be higher than that capital gains rate.

In essence, this means you don’t want to put your most tax efficient investments inside your annuity wrapper. “You want to put those higher yielding, less tax-efficient types of investments” inside your annuity wrapper.

Third, pay close attention to the credit rating of the company. “Make sure that it's a safe company,” he said. There are, for the record, five independent agencies—A.M. Best, Fitch, Kroll Bond Rating Agency, Moody’s  (MCO) - Get Moody's Corporation (MCO) Report and Standard & Poor’s—that rate the financial strength of insurance companies, according to the Insurance Information Institute.

Lastly, pay close attention to how much you’re paying for an annuity. “That wrapper may have a cost and there are opportunities to get that wrapper at a very reasonable cost, and there are some that are more expensive,” said Finke. “You have to pay attention to what it is that you're paying for, and whether or not you're receiving enough benefit to justify that expense.”