Consider proactive tax-management strategies
Most investors understand the value of asset allocation and investment selection in the wealth-building process. However, maximizing after-tax wealth remains an important priority, especially for high-income earners. In 2019, Americans collectively were expected to spend more on taxes than on food, clothing and housing combined1. Without the proper planning, investment earnings can make your tax burden even heavier.
Americans will spend more on taxes in 2019 than on food, clothing and housing combined
Source: Bureau of Economic Analysis: Tax Foundation calculation.
1 Tax Foundation, 2019.
Taxes can wait
Sheltering investment growth in tax-deferred accounts over the long term may result in more wealth for retirement. The value of tax deferral in this example is equivalent to a 0.7% higher annual return over the time period.
Tax-deferred annuities likely to remain attractive
While recent tax laws lowered the top marginal tax rate and expanded some income tax brackets, tax-deferred investing continues to be a valuable retirement saving strategy. The longer money is invested, the greater the benefit from tax deferral and compounding. Investors may consider using tax-efficient investing vehicles, such as variable annuities, whose assets generate ordinary income and short-term capital gains. Variable annuities defer the recognition of earnings and gains for income tax purposes, providing significantly more tax-deferred growth over time, after the extra costs of these vehicles are taken into account. For investors with a higher tax liability and higher investment returns, the benefits of a variable annuity could be even greater.
The gap between a taxable vs. tax-deferred account grows larger as the time frame becomes longer — that’s the power of tax-deferred compounding
1. $100,000 initial investment
2. 24% tax rate
3. 6.25% compounded annual rate of return
Source: J.P. Morgan Asset Management. Chart assumes an initial after-tax account value of $100,000 for each account type. Assumes a 6.25% annual return for both accounts. Investment returns in taxable account are taxed annually at 24% (capital gains and qualified dividends are not considered in this analysis). Tax-deferred account balance is taken as a lump sum after year 30 and investment returns (account balance net of initial investment) are taxed at 24% federal tax rate. If tax-deferred account is taken as lump sum at other tax rates, the after-tax balance would be $554,400 (12%), $502,800 (22%), $451,200 (32%), $435,700 (35%) and $425,300 (37%). This hypothetical illustration is not indicative of any specific investment and does not reflect the impact of fees or expenses. This chart is for illustrative purposes only. Past performance is no guarantee of future results.
Keeping more of what you earn
All investors must pay their fair share of taxes. Our complicated U.S. tax code recognizes different sources of investment gains and taxes them at different rates. In some instances, the taxation of these gains may occur at a later time (“tax deferral”), which allows for compounded growth as well as the deferral of ordinary income taxation.
Some asset classes are more tax efficient than others
Many asset classes held in taxable accounts — including fixed income, hedge funds, REITs and some equities — are tax inefficient. In other words, the gains on these investments may be taxed either at the individual’s highest tax rate or on an annual basis, or both.
Assets at the individual’s highest income tax rate that produce less tax-efficient returns, and that have longer holding periods, can underscore the value to investors of holding these assets in a tax-deferred vehicle. J.P. Morgan estimates that a variable annuity has potential to provide an investment benefit that could possibly exceed 100 basis points per year.
Over the last 15 years, some of the best-performing asset classes were also some of the most tax inefficient
This chart is hypothetical and for illustrative purposes only. Past performance is no guarantee of comparable future results.
What’s the difference between tax-efficient and tax-inefficient investments?
An investment’s tax efficiency is determined by both its expected return and the tax rate on such return.
- As a general rule, bonds or bond funds may be more tax inefficient because almost all of the return comes from the dividend yield, which is fully taxed as ordinary income.
- In contrast, stocks get most of their return from price appreciation. You’re not taxed until the stocks are sold and the gains are taxed at the capital-gains tax rate. Shares held for longer than one year are subject to long-term tax rates.
- Stock funds can be tax inefficient if they generate a lot of short-term gains; they are also less efficient if they pay high ordinary dividends. Under current law, qualified dividends are taxed at lower rates.
Why does it matter?
Taxes can have a big impact on long-term investment returns — making the benefit of a tax-deferred variable annuity especially attractive for high net worth and affluent investors focused on retirement.
While taxes should not be the sole driver of investment decisions, investors should be tax aware
When do you have to pay federal taxes on investment earnings?
It depends on what type of account you own. Here are some guidelines:
- Taxable account: Taxes are payable in the year in which returns are earned.
- Tax-deferred accounts: Investment earnings in traditional IRAs, 401(k)s and annuities aren’t taxed until withdrawn. Early withdrawals before age 59½ usually incur an additional 10% federal penalty tax. Distributions from qualified accounts must begin by or before age 72 (70½ if you reach 70½ before January 1, 2020).
Who might benefit most from a tax-deferred variable annuity ?
- Individuals with high marginal income tax rates: As a general rule, the higher an investor’s marginal income tax rates, the greater the advantages of tax deferral.
- Those who expect lower marginal taxes at retirement — when withdrawals will be taxed at a then-lower rate.
- Investors with 10 or more years to retirement: Time is a significant factor, as the compounded advantages of tax-deferred earnings help build account values effectively. The advantage of tax deferral is proportional to the amount of time available before assets are withdrawn from the deferred account.
- Investors who hold a significant share of assets in taxable accounts: Variable annuities may be an attractive option for investors who have maxed out their employer plans and IRAs.
Top tax rates for ordinary income, capital gains and dividend income
Source: J.P. Morgan Asset Management 2022 Guide to Retirement, page 51.
*Includes top tax rate plus 3.8% Medicare tax on the lessor of net investment income or excess of MAGI over threshold (single threshold $200,000; married filing jointly $250,000).
**The exemption amount is reduced .25 for every $1 of AMTI (income) above the threshold amount for the taxpayer’s filing status. For AMTI above the top range, the exemption will be $0.