Should Annuities be Purchased from Tax-Sheltered Assets?

Abstract

Retirees who purchase an annuity may assume that retirement savings accounts are ideal for funding retirement income. Annuities, however, are a tax-favored investment. We investigate the relative benefits of purchasing an annuity from tax-deferred and taxable accounts for various payout levels, tax rates, asset tax efficiency, and assumed portfolio rates of return. We find considerable evidence that investors are better off using non-qualified accounts to purchase annuities, although the benefits vary significantly by investor characteristics and the tax efficiency of investments held in non-qualified savings. In some cases, selecting the right account increases the after-tax income by over 10% which is equivalent to approximately 50 basis points of added portfolio return. A 15-year deferred annuity purchased from non-qualified vs. qualified bonds earning 4% provides over 30% more after-tax income for a 65-year old with a 40% marginal tax rate.

Keywords: annuities, retirement, personal finance

JEL Classification: D14, G11, J26