Tax Strategy · Education
Tax-Equivalent Yield of Fixed Annuities
The honest number behind "tax-deferred." A 5.55% fixed annuity is not worth 7.6% to a taxable investor — here's the correct formula, why the common shortcut overstates it, and the real (modest) edge tax deferral gives you.
The Bottom Line
A 5.55% APY annuity held 7 years at a 27% marginal rate has a true tax-equivalent yield of 5.78% — a +0.23 point edge, not +2 points.
The deferral benefit is real but small, because you eventually pay tax on all the gains. It stacks on top of annuities' already higher headline rates — not a substitute for them.
What tax-equivalent yield actually means
Tax-equivalent yield (TEY) is the yield a fully taxable investment — a bank CD or corporate bond whose interest is taxed every year — would need to pay to match the after-tax return of a tax-advantaged investment. For a tax-free investment like a municipal bond, the math is simple: divide the yield by (1 − your tax rate). For a tax-deferred investment like a fixed annuity, the math is different, because you don't avoid tax — you postpone it.
With a fixed annuity, your gains compound untaxed year after year, but when you withdraw (or when the contract matures and you cash out), you pay ordinary income tax on all the accumulated gains at once. That means the deferral benefit comes only from the extra compounding those gains earn during the term — not from never paying tax. The longer the term, the bigger (but still modest) the benefit.
The common mistake: 5.5% ≠ 7.6%
You'll often see annuity marketing turn a 5.55% rate into a 7.6% "tax-equivalent yield" using the municipal bond formula:
TEY = rate ÷ (1 − tax) = 5.55% ÷ (1 − 0.27) = 7.60%
This is wrong for a tax-deferred annuity. That formula assumes you never pay tax — which is true for a municipal bond or Roth IRA, but not for an annuity. Using it overstates the benefit by roughly 2 full percentage points. The real edge from deferral, over a 7-year term, is about +0.23 points.
The correct tax-deferred formula
We solve for the taxable rate rt that leaves the exact same after-tax dollars after n years. On the left, a taxable investment where interest is taxed each year (so only (1 − tax) of the interest reinvests). On the right, the annuity grows at the full rate, then tax is paid once at the end on the total gain:
(1 + rt · (1 − tax))n = (1 − tax) · (1 + r)n + tax
rt = [ ((1 − tax)·(1 + r)n + tax)1/n − 1 ] ÷ (1 − tax)
Notice the "+ tax" on the right side — that's the principal you get back tax-free (you're only taxed on gains, not your original premium). That term is what makes the tax-deferred TEY smaller than the tax-free TEY.
Worked example: 5.55% annuity, 7-year term, 27% tax
- • Annuity grows to (1 + 0.0555)7 = 1.4595× your principal
- • Tax paid at withdrawal on gains: (1.4595 − 1) × 0.27 = 0.1241× principal
- • After-tax value: 1.3354× principal
- • Equivalent taxable yield needed: 5.78%
- • Real deferral edge over the headline rate: +0.23 points
How the TEY changes with the term
Longer terms let gains compound untaxed for more years, so the deferral edge grows with time — but it's always a fraction of a point, not multiple points:
| Term | Annuity APY | Tax-Equivalent Yield | Deferral Edge |
|---|---|---|---|
| 3 years | 5.55% | 5.63% | +0.08 pts |
| 5 years | 5.55% | 5.71% | +0.16 pts |
| 7 years | 5.55% | 5.78% | +0.23 pts |
| 10 years | 5.55% | 5.88% | +0.33 pts |
How the TEY changes with your tax bracket
Higher marginal rates mean a bigger deferral benefit, because each year of deferral shields more tax. Here's the 7-year TEY for a 5.55% annuity across combined federal + state brackets:
| Combined Marginal Rate | Annuity APY | Tax-Equivalent Yield | Deferral Edge |
|---|---|---|---|
| 12% | 5.55% | 5.65% | +0.10 pts |
| 22% | 5.55% | 5.73% | +0.18 pts |
| 27% | 5.55% | 5.78% | +0.23 pts |
| 32% | 5.55% | 5.82% | +0.27 pts |
| 37% | 5.55% | 5.87% | +0.32 pts |
| 42% | 5.55% | 5.92% | +0.37 pts |
Tax-deferred vs. tax-free: what's the difference?
Tax-free (Roth IRA, muni bond)
You never pay tax on the gains. TEY = rate ÷ (1 − tax). A 5.5% muni at 27% tax really is worth 7.6% to a taxable investor.
Tax-deferred (fixed annuity, trad. IRA)
You postpone tax on gains until withdrawal, then pay ordinary income tax on all of it. TEY is term-dependent and much smaller — about 5.78% here.
Does TEY matter inside an IRA or 401(k)?
Not really. Inside a Roth IRA, annuity gains are tax-free, so the TEY equals the annuity rate — no adjustment needed. Inside a traditional IRA or 401(k), the account is already tax-deferred, so buying an annuity there adds no extra deferral benefit. The TEY comparison matters most for non-qualified (after-tax) annuity purchases held outside retirement accounts — where the deferral is the annuity's unique tax advantage.
The honest takeaway
Tax deferral is a genuine, if modest, benefit of fixed annuities held outside retirement accounts — worth roughly a quarter of a percentage point per year over a typical term. It is not a reason to pretend a 5.55% annuity is a 7.6% investment. The real case for a fixed annuity is its higher headline rate than comparable CDs and bonds, plus principal protection and predictable growth — with tax deferral as a small bonus on top.
Annuity Quote Calculator
See your guaranteed return in 60 seconds
Annuity vs CD After Tax
Full side-by-side after-tax comparison
Browse Fixed Annuities
Today's guaranteed rates from A-rated carriers
Annuity Payout Calculator
How much your premium actually earns
Illustration only. Tax-equivalent yield compares a tax-deferred annuity (tax paid once at withdrawal on the gains) to a fully taxable investment taxed on interest each year, over the same term. Actual tax treatment depends on your individual circumstances — consult a qualified tax advisor. Withdrawals before age 59½ may incur IRS penalties. Annuital is a DBA of Small Business Insurance Agency, Inc., a Massachusetts licensed insurance agency. Products not available in CA or NY.