A great way to make investments grow is by compounding. Generally, the greater the compounding, the faster the investment growth. However, there is more to compounding than just this statement. For instance, an increase in the compounding rate from 6% to 8% ( a 33 % increase in the rate ) can increase the investment by 75% over 30 years. For this reason, Einstein said that compound interest was one of the great wonders of the world! Please see the first table. This magical increase is what makes tax-deferred investments so advantageous and what makes rich people rich. Take a look at the figures below.
Per Cent Greater Accumulation for 8% over 6% Compound Rates of $10,000
Year 6% 8% % more
5 13,382 14,693 10%
10 17,908 21,589 21%
15 23,966 31,722 32%
20 32,071 46,610 45%
25 42,919 68,485 60%
30 57,435 100,627 75%
A taxable account generates interest or dividend earnings that are taxed annually. If the investment returns 10% and is taxed at the 28% rate, then 28% of the 10% (that is, 2.8%) of the return on investment is taxed. This means that only 7.2% (against the full 10%) can be used for compounding.
However, tax deferred annuities ensure that the earnings are not taxed annually. This means the entire 10% return on investment will be available for compounding. So you don't need to be rich to get richer. Use deferred annuities to compound your money faster!
Keeping the effect of taxation on compound rates, we now need to calculate how much more the earnings rate on a taxable account should be to equal the growth potential of a tax-deferred annuity. This figure needs to take in to account the investor's tax bracket.
This comparison is essential for retired individuals looking to putting money aside for the purchase of deferred annuities in the event of a longer-than-anticipated life. Deferred annuities are therefore often referred to as "longevity insurance." Retirees need to consider whether money in secure investments such as treasury bonds or money in deferred annuities is likely to grow to a larger sum. Since many secure investments such as bonds have their earnings taxed annually, there is a need to compare growth rates of the different investment options.
The tax rate on extra earnings received will be determined by your tax bracket. That is, the interest earnings from investment in bonds will be combined with your other income from part-time work, pension, and social security if that is taxable in your case. The tax brackets are between 10% and 35%. of course, none of this applies to the growth phase of deferred annuities and thus their advantage as capital accumulation tools.
The table below shows the taxable earnings rate (that is subject to annual taxation) you must receive to have a compounding rate that equals deferred annuities earnings rate for various tax brackets.
Taxable Earnings Needed to Compound Equally to Tax-Deferred Earnings
Federal Income Tax Brackets
10% 15% 25% 28% 33% 35%
Tax-Deferred
Earnings Equivalent Taxable Earnings
at Each Tax Bracket
8% 8.89% 9.41% 10.67% 11.11% 11.94% 12.31%
7% 7.78% 8.24% 9.33% 9.72% 10.45% 10.77%
6% 6.67% 7.06% 8.00% 8.33% 8.96% 9.23%
5% 5.56% 5.88% 6.67% 6.94% 7.46% 7.69%
4% 4.44% 4.71% 5.33% 5.56% 5.97% 6.15%
In other words, if you are in the 28% tax bracket, you would need to earn 5.56% on a taxable account to get the same growth as 4% deferred annuities would provide. If you need to check the earning rates of deferred annuities, all you need to do is look up the deferred annuity rates.
Please note that deferred annuities cannot be surrendered for value once they are annuitized. The income from deferred annuities is taxed in the same manner as ordinary income. Withdrawals before the age of 59 ½ are imposed with a 10% penalty. The income from annuitization is divided into two and part is taxed as ordinary income and the rest as return of capital. All guarantees depend on the ability of the insurance company to pay the claims. Deferred annuities are essentially long-term investments. As deferred annuities are classified as insurance products, they are subject to insurance related expenses and fees.
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