The individual retirement account is quickly becoming a popular way to save for retirement. But many people have begun looking for tax-sheltered ways to save for other future expenses, like college expenses, that trip around the world, or the second home that will become the primary residence after retirement. The heavy penalties on early IRA withdrawals, after all, make them unattractive for these needs.
One alternative for this situation may be a tax-deferred annuity. Even though you pay taxes on the money when you take it out, the assets accumulate more quickly because they grow tax-free. So you are earning interest on the original investment, on the growing and compounding interest, and on the money you're not paying in taxes.
The effect of tax deferral can be significant, notes a publication listing tax-saving ideas from Merrill Lynch, Pierce, Fenner & Smith Inc. For instance, if you are in the 50 percent tax bracket and put $25,000 into a tax-deferred annuity that pays 12 percent a year tax deferred for 21 years, at the end of that time you would have $270,000.
If you stay in that 50 percent tax bracket and put that $25,000 into a taxable investment that paid 12 percent a year for the same period, you would only have about $85,000, Merrill Lynch notes.
All of the money used to buy a tax-deferred annuity goes to work immediately because there is no sales charge. The minimum purchase for most single-premium deferred annuities is about $5,000. With some annuities, you have to purchase an entire new policy to add money. But with others, you can add to the original policy.
Normally payments to you from the annuity can begin whenever you choose - in 10 years, for example, if you plan to use the money for college expenses. Or you may choose to have payments begin in 20 years if the money is being used to supplement retirement income.
Of course, the longer the money remains in the annuity, the more time it will have to accumulate interest. Also, if withdrawals start at retirement, you will probably be in a lower tax bracket, which means you get to keep more of the money.
Be sure, however, that you will not be needing the money during the contract period. Under the 1982 tax act, withdrawals from an annuity contract are taxed as income rather than being treated as tax-free return on principal. This applies to annuity contracts purchased or additional investments made after Aug. 13, 1982.
Also, effective Jan. 1, 1983, an investor under age 591/2 who withdraws money during the annuity accumulation period must pay a 5 percent tax penalty on withdrawals made within 10 years of putting the money into the annuity.
Even though inflation has moderated somewhat in recent years, it should still be taken into consideration in any program to build savings. So even if you already have a pension or profit-sharing plan, an annuity can be a good way to ensure adequate income during retirement.