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The Power of Tax-Deferral Annuities have two stages: the accumulation phase and the payout phase. During the accumulation phase, you make purchase payments to the annuity, either in one lump sum or on an on-going basis. Depending on what type of annuity you own, during the accumulation phase, your annuity's value will grow based on an interest rate set by the insurance company (fixed annuity), or fluctuate depending on the value of the sub-accounts (variable annuity). In either case, an annuity grows tax-deferred during the accumulation phase. Tax-deferred is not the same as "tax-free." Tax-free investments, such as most municipal bonds, incur no income taxes on gains. Annuities are taxed on their gains, but only when you choose to withdraw those gains from the annuity. Tax-deferral is a powerful tool, especially over the long haul. Here's just one example: John Smith, currently in the 28% tax bracket, inherits $10,000. He places the $10,000 in a savings account and holds it for ten years. He is taxed at the end of every year on his gains. His accumulation looks like this:
John's sister, Jane, decides to use her $10,000 inheritance to purchase a $10,000 annuity. She is also in the 28% tax bracket, and will hold it for ten years. She is only taxed when she decides to withdraw her money. When compared to John, Jane used the power of tax-deferral to her advantage:
Tax-deferral provides this added value, because of the time value of money. After all, Jane's annuity earned interest on money that John paid every year in taxes. The power of tax deferral is clear, particularly if both options are earning the same rate, and held beyond their maturity date. Also keep in mind that with higher interest rates, higher tax brackets, and longer maturities, the power of tax-deferral becomes even more apparent.
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