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Annuities Deferred Income Annuities Income Tax Planning Retirement Income Planning

Nonqualified Fixed Income Annuities: A Timeless Tax and Retirement Income Planning Opportunity

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

President Biden’s American Families Plan includes proposed increases in the top marginal income tax rate from 37% to 39.6% and the top long-term capital gains tax rate from 23.8% to 43.4% for households with income over $1 million. Both changes would negatively impact investment returns for affected individuals.

Stock market-based investment strategies, with their exposure to higher ordinary and long-term capital gains tax rates are being reevaluated by investors and financial advisers alike. One strategy that is attracting more attention that will be virtually unscathed by the proposed tax increase is longevity insurance, more commonly known as fixed income annuities.

Three Types of Fixed Income Annuities

Fixed income annuities provide sustainable lifetime or term certain income and, as such, are well suited for retirement income planning. There are three types of fixed income annuities:  single-premium immediate annuities (SPIAs), deferred income annuities (DIAs), and fixed index annuities (FIAs) with income riders.

Each of the three types of fixed income annuities serve a different purpose within a retirement income plan. Two of the three options, SPIAs and DIAs, are tax-favored when purchased in a nonqualified, or nonretirement, account. This makes them an excellent choice for those in higher tax brackets who are seeking to maximize after-tax sustainable income.

SPIAs can be an appropriate retirement income planning solution if you are retiring soon or are retired and have an immediate need for sustainable income. Income distributions can be as frequent as monthly or as infrequent as annually (depending on the options available from the insurer), as long as the first benefit is paid within one year of the contract’s purchase date.

DIAs are a better fit than SPIAs in most retirement income planning scenarios due to their deferred income start date. Deferral of your income start date increases the amount of your periodic income payment since the insurance company will be making payments to you for a shorter period of time assuming a lifetime payout.

100% of income distributions from FIAs with income riders are taxed as ordinary income whether they are in a retirement or nonretirement account. While their flexible income start date and potential death benefit are attractive features, income tax savings is not a strong suit of FIAs with income riders.

DIAs and SPIAs Unique Income Tax Advantage

DIAs and SPIAs enjoy a unique income tax advantage when they are purchased in a nonretirement account. Unlike FIAs with income riders that distribute ordinary income that reduces the accumulation value of the annuity contract, DIAs and SPIAs are annuitized.

The annuitization period is defined by the contract and is either a defined term, e.g., 10 years, or lifetime. Lifetime DIAs and SPIAs provide for an optional minimum payout period or lump sum payable to the annuitant’s beneficiaries to guarantee a minimum total payout.

The income tax advantage of DIAs and SPIAs is attributable to the allocation of each annuitized payment between income and a return of premium. The portion that is deemed to be a return of premium is your cost, or basis, and is nontaxable. Annuitization is analogous to amortization of a mortgage. When you make a mortgage payment, each payment is allocated between deductible interest and nondeductible principal.

In the case of a DIA or SPIA, the amount of each payment that is considered to be a nontaxable return of premium is calculated by applying an “exclusion ratio” to each monthly payment. The exclusion ratio is actuarially calculated by dividing the investment in an annuity contract by the total expected lifetime payments.

SPIA Tax Savings Illustration

To illustrate the income tax advantage of nonretirement DIAs and SPIAs, suppose you are a woman, and you purchase a SPIA for $100,000 when you are 65 years old. Let us further assume that the insurance company determines that you have a 22-year life expectancy, and they will pay you $475 a month for the rest of your life. Your lifetime payments are expected to total $125,400 ($475 x 12 x 22).

Your exclusion ratio is calculated by dividing your premium, or investment, of $100,000 by your expected lifetime payments of $125,400. The result is that 79.75%, or $379, of each of your monthly payments of $475 will be nontaxable for the first 22 years. 20.25%, or $96, of each  monthly payment will be taxable. Even though your annual payments will total $5,700, the insurance company will report taxable income of only $1,154 for the initial 22 years.

What happens if you survive your 22-year life expectancy? You will continue to receive monthly payments of $475 for the rest of your life, however, 100% of your monthly payments will be taxable as ordinary income. This makes sense since your nontaxable payments for the first 22 years will have totaled $100,000 which is equal to your original investment.

Nonretirement DIAs and SPIAs Can Optimize After-Tax Retirement Income

DIAs and SPIAs, like all fixed income annuities, provide sustainable lifetime income. When purchased in a nonretirement account, they distinguish themselves further as a retirement income planning solution since their after-tax income is predictable.

Income tax rates have minimal impact on the amount of after-tax income from DIAs and SPIAs due to their exclusion ratio. Furthermore, any increase in marginal income tax rates will not affect most annuitants’ after-tax periodic payments until cost basis has been recovered. As illustrated, this will not occur until the annuitant survives her life expectancy beginning on the annuity purchase date.

The ability to optimize after-tax income from nonretirement DIAs and SPIAs can also result in spillover income tax and other savings. This includes the potential reduction of taxable Social Security benefits, reduced exposure to the 3.8% net investment income tax, increased potential deductibility of medical expenses, and the opportunity to reduce marginal income tax rates and Medicare Part B premiums. Each of these things individually and collectively can result in additional increased after-tax retirement income for the duration of retirement.

Nonretirement fixed income annuities, with their sustainable lifetime income and tax-favored status, offer a timeless tax and retirement income planning opportunity.

Categories
Annuities Deferred Income Annuities Fixed Index Annuities

Take Some Chips Off the Table and Add Them to Older Income FIAs

This article was originally published in, and has been reprinted with permission from, Retirement Daily.

Every year since 2014 when I purchased a fixed index annuity (FIA) with an income rider in my SEP-IRA, I have added $20,000 to it. Furthermore, I plan on continuing to do this until I retire.

Why did I purchase a FIA with an income rider in my SEP-IRA in 2014 and add to it each year? For the same reasons that I am making the recommendation to do so today.

Stock Market Euphoria is Cause for Evaluation

As I write this article, the Dow Jones Industrial Average (DJIA) is hovering at just below 31,000 after reaching an all-time high of 31,653.48 on February 22nd.  The DJIA increased 13,440 points, or 74%, since its Covid low of 18,213.65 just 11 months ago on March 23, 2020.

While Covid-19 cases, hospitalizations, and deaths have all recently dropped and more people are getting vaccinated which has contributed to the sizable stock market increase, the party and associated euphoria will not last forever. With the exception of last year’s first quarter drop, the stock market has been on steroids since hitting a low of 6,469.95 on March 6, 2009 after declining 52% in 17 months beginning in October, 2007.

The DJIA has increased 480% in the last 12 years, or 40% per year on average, which is obviously not sustainable. Do the terms “bear market” or “reversion to the mean” ring a bell?

Pivot Into Sustainable Income

I have been extolling the virtues of making sustainable income the cornerstone of a retirement income plan since 2009 when I began specializing in retirement income planning. The 52% stock market decline in 17 months, combined with the elimination of secure lifetime income provided by private pension plans, created a perfect storm for implementing this strategy.

While my clients are happy with the 12-year increase in their portfolio values, I know from many years of experience that this state of exuberance is often short-lived. The reality is that their equity allocation is greater than what is targeted for their portfolio in several cases.

As a retirement income planner, I look for windows of opportunity for my clients to transfer slivers of their investment portfolio from the unpredictable fluctuation of the stock market to fixed income annuities that are designed to provide sustainable income that they can depend on throughout retirement.

There are three types of fixed income annuities that can be employed for this purpose:  single premium immediate annuities (SPIAs), deferred income annuities (DIAs), and fixed index annuities (FIAs). Some FIAs have an income payout feature built into them while others require purchase of an income rider.

Add to Older Income FIAs

All payouts from fixed income annuities are calculated using mortality credits, or life expectancy, and current interest rates. If you invest in a SPIA or DIA today, your payout will be relatively low compared to three or more years ago because of declining interest rates. In the case of DIAs, this is true whether it is a new or an existing contract.

Income FIAs that were purchased between 2009 and 2018, including the one that I chose for my SEP-IRA in 2014, provide a unique opportunity for increased sustainable income payouts when new premium dollars are added compared to current SPIA, DIA and income FIA offerings. This is because the income payout for FIAs is calculated using a formula and the variables used to calculate the payout were more favorable and less likely to be tied to performance of the underlying contract accumulation value as is often done today.

The following four variables are responsible for higher income payouts in older income FIAs:

  • Higher interest rates in the growth phase
  • Wider availability of compound interest crediting in the growth phase
  • Ability to extend initial growth phase interest crediting from 10 to up to 20 years
  • Premium bonuses offered for longer periods of time, as much as five to seven contract years in some cases

Besides the more favorable variables, there was greater availability of flexible vs. single premium contracts. Funds cannot be added after the first contract year to a single-premium FIA. Flexible premium FIAs, on the other hand, allow for subsequent investments after the initial contract year. Some flexible premium FIAs do, however, place caps on the amounts of annual additions. Finally, qualified, or retirement plan annuities, such as my SEP-IRA, are subject to annual contribution limits.

Exercise Option to Extend Income FIA Growth Phase Interest Crediting

In addition to adding new premium dollars, anyone with an income FIA that was issued between 2009 and 2018 who has not begun taking income distributions should exercise their option to extend the initial growth phase interest crediting if this is available.

With the growing popularity of income FIAs beginning in 2009, a larger number of contracts offering the ability to extend interest crediting beyond 10 years are in play. If you have one of these contracts and have not started your lifetime income, it behooves you to exercise your interest crediting extension option.

This is a no-brainer since the crediting of additional interest, which can be for up to 10 years in some cases, will increase your income payout amount. The increase could be substantial if, for example, your contract provides for 8% compound interest crediting, you extend the growth period from 10 to 20 years, and you defer your lifetime income withdrawal start date.

Opportune Time to Purchase or Add Funds to Fixed Income Annuities

This is a great time to purchase or add funds to fixed income annuities as part of an overall retirement income plan given the continued escalating stock market highs. Shifting a portion of one’s investment portfolio to sustainable lifetime income at opportune moments is a proven long-term strategy, especially if you are within 20 years of, or in, retirement.

Employing this strategy can enable you to accomplish two important goals shared by all individuals doing retirement income planning: portfolio risk reduction and decreased likelihood of running out of money in retirement.

Surveys as well as personal and client experience show that having predictable retirement income results in reduced short- and long-term stress levels, fewer cases of insomnia, and less health issues in general. This unequivocally trumps the often short-lived euphoria associated with increasing portfolio values in a bull market.

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Annuities Deferred Income Annuities Long-Term Care Retirement Income Planning Roth IRA Social Security

5 Lifetime Valentine’s Day Gifts for Your Spouse

The mad scramble is on. With Valentine’s Day just around the corner, what should you buy your spouse to show him/her your everlasting love and appreciation? Forget about traditional gifts such as roses and chocolate that are short-lived and just as quickly forgotten.

Here are five unique ideas you won’t find on Amazon that are designed to fulfill you and your spouse throughout your life. A word of caution:  Brush up on your presentation skills since each one will likely be met with dead silence or outrage depending upon the mood of your spouse.

VD Gift Idea #1:  Eliminate Your Mortgage by Retirement

One of the biggest cash flow challenges for many retirees is their mortgage. When you apply for a mortgage while you’re working, the mortgage amount and associated monthly payment is determined using your employment income.

Although your employment income generally increases, so do your expenses. When you retire, your guaranteed sources of income that are available to cover your mortgage payments are often a small percentage of your former employment income.

Given this common scenario, you should design a plan to eliminate your mortgage by retirement whenever possible. This can include an increase in your monthly payment amount, making bi-weekly payments, or using a portion of bonuses to reduce your outstanding balance. Your plan should be part of an overall strategy that includes various savings vehicles.

VD Gift Idea #2:  Defer Your Social Security Start Date

When your spouse dies, you can generally receive 100 percent of his/her Social Security retirement benefit if (a) the amount exceeds your benefit and (b) you have reached your full retirement age, which is between 66 years and two months and 67 depending upon when you were born. This is the good news.

The bad news is that the monthly amount that you receive for your lifetime could be significantly less than what you would otherwise qualify for depending upon when your spouse began collecting his/her benefits. The difference could be as much as 77% if he/she began collecting benefits at age 62 vs. waiting until 70.

Assuming that your Social Security benefit will be greater than your spouse’s, you’re in good health, you have other financial resources, and your goal is to maximize your spouse’s benefit in the event that you predecease him/her, it behooves you to defer your Social Security starting date as long as possible, up to age 70.

VD Gift #3:  Start a Staged Roth IRA Conversion Plan

While there are several benefits of a staged, or multi-year, Roth IRA conversion plan, one of the least publicized is the ability to reduce a widow or widower’s income tax liability. This is due to the fact that surviving spouses who don’t remarry are subject to higher income taxes.

Distributions from Roth IRA accounts, unlike traditional 401(k) plans and IRAs, generally aren’t taxable. A staged Roth IRA conversion plan can be used when both spouses are alive to convert otherwise taxable assets to nontaxable assets. Although income tax will probably need to be paid on the conversion amounts, the amount will be less in many cases than what will be payable by the surviving spouse, especially if income tax rates increase which is likely after 2025.

VD Gift #4:  Include Sustainable Lifetime Income in Your Retirement Plan

When you retire, you want to minimize sleepless nights by knowing that you have, and will continue to have, sufficient income to cover your expenses. Designing a plan that will provide you and your spouse with sustainable after-tax income streams to cover your non-discretionary expenses throughout different stages of retirement is an effective way to accomplish this goal.

There are five reasons for including sustainable lifetime income in your retirement plan that will benefit you and your spouse:

  • Hedge against longevity
  • Match income to projected expenses
  • Protect against the sequence of returns
  • Increase cash flow from potential income tax savings
  • Simplify your financial life

VD Gift #5:  Create an Extended Care Plan

I saved this idea for last since, although it’s potentially the most beneficial one, it’s also likely to be met with the most resistance. Previously suggested as a birthday gift for parents, it’s also suitable for one’s spouse on Valentine’s Day.

Extended care is the least understood and most under-planned for life event. When it’s needed, extended care takes its biggest toll on family and friends in the absence of a plan. Studies have shown that providing extended care for an individual who is chronically ill can have a devastating effect, both emotionally and financially, on caregivers.

An extended care plan may or may not include long term care insurance. When included, long term care insurance provides a predictable, readily available, tax-free source of funds that can be used to pay for a portion, or potentially all, of one’s extended care expenses without disrupting one’s retirement income plan.

The Gifts That Keep on Giving

While the foregoing Valentine’s Day gift suggestions aren’t traditional and won’t provide immediate gratification, each one is designed to fulfill you and your spouse throughout your life. Furthermore, all of them will eventually be appreciated by both of you, even after the other is gone.

If you’re looking for the ultimate gift, include each one as part of a comprehensive retirement income plan. Financial advisor sold separately. Finally, don’t forget the card. Happy Valentine’s Day!

Categories
Annuities Deferred Income Annuities Fixed Index Annuities Retirement Income Planning

Uneasy About the “A” Word? You’re Not Alone

Tilney, a highly-regarded financial planning firm in England where workers are automatically enrolled in employer pension plans unless they opt out, surveyed 1,300 employees in 2018 regarding what they planned to do with their pension when they retire. The results were as follows:

  • 40% said they didn’t know what they would do.
  • 22% said they expected to keep most of it invested, taking some withdrawals.
  • 10% would potentially cash it all in.
  • 10% would use the pension to buy an annuity.

When the word “annuity” was removed as an option and replaced with a “pension that provided a guaranteed income for life,” 79% of respondents said that this was more appealing than a plan where the value and income varied each year. This was the result despite the disclosure that a traditional investment plan offered the prospect for higher returns.

Income Optimization is the Appropriate Benchmark

Annuities have long been misunderstood. Fixed income annuities in particular are often rebuffed by investment professionals with little or no annuity education whose goal is to maximize investments under management and who don’t practice holistic retirement income planning.

Their use of investment returns as a frame of reference results in inevitable non-apples-to-apples comparisons to traditional equity-based investment portfolios. These individuals fail to acknowledge the fact that it’s impossible to calculate the return of a fixed income annuity until an annuitant has passed.

Income optimization, rather than investment return, is the appropriate benchmark that should be used when evaluating fixed income annuities for inclusion in a retirement income plan. The goal is to design a comprehensive strategy that uses the least amount of assets to purchase the greatest amount of sustainable after-tax lifetime income that’s projected to pay for expenses not covered by distributions from investment and other assets.

Purchasing Guaranteed Lifetime Income is Unnatural

In addition to being misunderstood, the concept of purchasing guaranteed lifetime income, especially when the income start date is deferred, is unnatural for most people. That’s generally the case until they realize that’s exactly what they’re doing with Social Security. In order to receive Social Security retirement benefits, you must purchase them.

What do I mean? Either your salary is reduced by a deduction for Social Security tax or, if self-employed, you’re subject to a self-employment tax until the maximum Social Security wage base, currently $132,900, is reached. Social Security withholding and/or self-employment tax is used to fund Social Security retirement benefits. In essence, you’re purchasing your benefits.

It’s more difficult to pull the trigger when you purchase sustainable lifetime income with a fixed income annuity because you’re not exchanging a lump sum for an investment of equal value unless you purchase a fixed index annuity (FIA). Instead, you’re entering into a contract in which a promise is made by a life insurance company to pay you a periodic income stream for life or a specified number of months or years beginning at a future date.

The contract is irrevocable in the case of single premium immediate annuities (SPIAs) and deferred income annuities (DIAs), i.e., your premiums won’t be returned to you by the insurance company unless you’re within the “free look” period. This is generally 10 days following the purchase date with up to 30 days for seniors in California.

Fixed Income Annuities Designed for Sustainable Lifetime Income

When presented in the context of retirement income planning, fixed income annuities have proven to be the most appropriate and natural commercial solution for providing sustainable lifetime income. The three types of fixed income annuities can be used individually, or in combination, to provide a hedge against the unpredictable stock market.

Fixed income annuities are often used in conjunction with other sources of guaranteed income such as Social Security and private or government pensions to allow retirees to sleep better at night. Nonqualified SPIAs and DIAs enjoy a competitive edge since a portion of each income payment is nontaxable.

Fixed Income Annuity or Pension That Provides Guaranteed Income for Life?

Assuming that you’re planning for retirement, would you rather purchase a lifetime fixed income annuity or a pension that provides guaranteed income for life? This is one decision you don’t have to worry about making since they both provide the same benefit, i.e., sustainable lifetime income that’s unaffected by the fluctuations of the stock market.

Categories
Annuities Deferred Income Annuities Retirement Income Planning

Protect Against Elder Fraud with Fixed Income Annuities

If you’ve been reading Retirement Income Visions™ and my RetireMentors MarketWatch column, you know that I’ve written extensively about the use of fixed income annuities as a retirement income planning strategy.

Fixed income annuities are a natural fit as part of a retirement income plan. They provide a predictable sustainable income stream that can be customized to meet current and projected financial needs.

An important, although unpublicized, benefit of fixed income annuities is protection against elder fraud. Earlier this year, the FBI brought charges against 250 subjects who collectively victimized more than one million mostly elderly Americans. The criminals who were charged caused losses exceeding $600 million.

Two of the three types of fixed income annuities – single premium immediate annuities (SPIAs) and deferred income annuities (DIAs) – offer the greatest protection against elder fraud. Fixed index annuities (FIAs) with income riders aren’t as effective for this purpose due to their accumulation value.

SPIA and DIA Basics

When you purchase a SPIA or DIA from a life insurance company, you receive a contract that includes confirmation of your initial, and, in the case of a SPIA, only premium. The contract also includes your income start date and payment frequency, amount, and duration.

Income payments from SPIAs generally begin one month after purchase and continue for life. The income start date for DIAs is at least 12 months after the purchase date, with term certain or lifetime payments, depending upon the terms of the contract. For both SPIAs and DIAs, there are various lifetime payment options available to provide for either an extension of income payments or payment of a lump sum to named beneficiaries in the event of premature death.

No Investment Account to Raid

With SPIAs and DIAs, there’s no investment account that can be raided by a fraudster. Premiums are held in the life insurance company’s general account. Aside from confirmations of premiums and associated income amounts, there are no investment statements.

Although the present value of the future income stream of SPIAs and DIAs can be calculated, it’s generally excluded from a personal net worth statement.

Secure but Illiquid

SPIAs and DIAs are a promise by a life insurance company to make periodic income payments to an annuitant, who is usually the contract owner, for a specified length of time in exchange for receipt of one or more premiums. Since the life insurance industry is heavily regulated, payments are secure subject to each company’s claims paying ability.

Other than periodic income, which is generally paid monthly, annuitants are unable to request withdrawals from SPIAs and DIAs. As such, their investment is illiquid. This is a highly attractive feature when it comes to elder fraud protection.

Payment Amounts Minimize Risk of Elder Fraud

Since income from SPIAs and DIAs is generally paid monthly over one’s lifetime, individual payments are typically small relative to premiums and are further reduced by income tax withholding. Consequently, the risk of elder fraud is minimized.

Assuming that payments are deposited into a checking account, frequent comparison of transactions and reconciliation of checking account balances to online transactions and statements, respectively, will reduce the possibility of theft.

Electronic Payments Enhance Protection

The option to have fixed income annuity payments electronically deposited into one’s checking account should be chosen whenever possible. Paper checks present opportunities for fraud from the moment they’re mailed by an insurance company until they’re deposited in one’s checking account.

Electronic payments have a high degree of security. Timing is predictable since fixed income annuity payments are made on a specified day of each month, quarter, or year in accordance with the contract terms.

Peace of Mind

Assuming that there’s no fraudulent activity related to premium payments, SPIAs and DIAs are well-suited for providing ongoing protection against elder fraud. Absence of an investment account, payment security, illiquidity, relatively small payment amounts, and electronic payments provide this safety.

These same features are also inherent in Social Security. SPIA and DIA owners who understand this generally have peace of mind from their initial purchase until receipt of the final income payment.

Categories
Annuities Deferred Income Annuities Income Tax Planning Long-Term Care Longevity Insurance Retirement Income Planning

The Perfect Storm for a Tax Credit Longevity Annuity Plan

With momentum building for tax reform, concerns about the long-term sustainability of Social Security, widespread lack of long-term care protection planning, and the failure of 401(k) plans to replace private pension plans that were once a cornerstone of our parents’ and grandparents’ retirement income, we have the perfect storm for Congress to introduce, and the President to sign, Tax Credit Longevity Annuity Plan legislation.

Similar to a qualifying longevity annuity contract, or QLAC, which was enacted in 2014, a Tax Credit Longevity Annuity Plan, or TCLAP, (my creation) would use one or more deferred income annuities, or DIAs, offered by life insurance companies as its chassis.

Deferred Income Annuity Advantages

DIAs offer three advantages over traditional savings vehicles which make them attractive as the foundation of a comprehensive retirement income planning strategy:

While payment options include a fixed term or lifetime, most people opt for the latter. When you purchase a DIA, you choose a deferred income start date. Once payments begin, they continue for the life of the annuitant and a joint annuitant if applicable assuming a lifetime payment option is chosen.

  • Locked-in savings plan

A DIA is irrevocable. Unlike traditional retirement savings plans from which funds can be withdrawn before retirement resulting in premature depletion, you enter into a contractual relationship with a life insurance company when you purchase a DIA. The contract provides that you will receive a defined monthly income beginning on a specified future date in exchange for a specified premium. Unless there’s a return of premium provision included in your contract, your premium is nonrefundable.

Subject to the claims-paying ability of individual life insurance companies, funds allocated to DIAs are protected against stock market declines. Individuals who purchase DIAs will receive a contractually-fixed amount of lifetime income beginning on a certain date even if there’s a major stock market correction.

12 Proposed Provisions

A Tax Credit Longevity Annuity Plan, or TCLAP, if enacted, would expand upon, and overcome, various shortcomings associated with QLACs. Periodic income payments would be similar to comparable non-TCLAP DIAs. There would be 12 proposed provisions as follows:

1.  Nonqualified Investment

Most people associate retirement planning with investing in qualified retirement plans such as 401(k)s and IRAs. To the extent that you make deductible contributions to these types of plans, 100% of your distributions will eventually be taxable. This wouldn’t be so bad if you invested the tax savings from your deductible contributions and used them for retirement, however, most people don’t do this.

Unlike a QLAC which can only be used inside retirement plans, the source of TCLAP investments would be nonqualified funds. Although income payments would still be taxable, a sizable portion would be exempt from taxation. This is due to the fact that an “exclusion ratio” is applied to nonqualified DIA distributions.

An exclusion ratio reduces the amount of taxable DIA distributions by the portion of each distribution that’s deemed to be a return of investment. The ratio is equal to your investment in the contract divided by your expected return based on your actuarial life expectancy at the age that you begin receiving distributions.

Approximately 25% to 65% of each income payment can be excluded from taxation depending upon your age when you begin receiving your distributions. The percentage that’s initially used will continue until you reach your actuarial life expectancy and your cumulative payments equal your total investment in your contract. 100% of future payments are taxable once this occurs.

2.  Additional Premiums

While several DIAs allow for subsequent investments in future years, there are several that limit investment to a single premium. Given the fact that the purpose of a TCLAP would be to meet sustainable income needs not fulfilled by other sources such as Social Security, a single premium would generally be insufficient.

Given this reality, a TCLAP carrier would accept initial and subsequent premiums up to a specified period, e.g., two years, prior to the income start date.

3.  Investment Tax Credit for Initial and Subsequent Investments

One of the most compelling ways to incentivize behavior is with tax credits. A tax credit, unlike a tax deduction which is dependent upon one’s marginal tax bracket for determining the amount of tax savings, is a direct offset to tax liability. Most tax credits today, with the exception of residential energy and credits for all-electric and plug-in hybrid vehicles, the latter of which can be as much as $7,500, are subject to income limitations.

Assuming that the purpose of tax reform is to benefit the middle class, the long-term sustainability of Social Security is questionable, and Congress wants to encourage and promote self-funded private pension plans, an investment tax credit equal to a percentage of initial and subsequent investments makes sense. The percentage would be modest to compensate for the fact that a sizable portion of income distributions will be nontaxable.

In order to encourage individuals to direct a high level of their savings into TCLAPs beginning at an early age to produce a significant amount of sustainable income to pay for their retirement expenses, I would recommend that Congress support a tax credit equal to 8% of initial and subsequent investments for individuals who aren’t qualified retirement plan participants and 4% for those who are. This would go a long way toward subsidizing investment in TCLAPs that wouldn’t otherwise be made in most cases.

4.  Annual and Lifetime Investment Limitation

Given the fact that a sizable investment in a fixed income annuity such as a DIA is required in order to receive a meaningful amount of income, there should be a reasonably high limit on the amount of allowable initial and subsequent investments in TCLAPs.

I would propose a limit of $100,000 in the initial contribution year and $50,000 in subsequent years with a lifetime limit of $750,000 per household. This would result in a maximum investment tax credit of $8,000 (8% x $100,000) or $4,000 (4% x $100,000) in the initial year and $4,000 (8% x $50,000) or $2,000 (4% x $50,000) in subsequent years depending upon participation in a qualified retirement plan.

5.  Minimum Investment Amounts

As stated in the previous section, a sizable investment in a DIA is required in order to receive a meaningful amount of income. The amount of income in each situation is different depending upon each individual’s retirement income planning needs, the percentage of total income that’s targeted from sustainable income sources, and the amount that will be provided by other sources, e.g., Social Security.

Having said this, minimum investment amounts need to be established that will help meet one’s planning needs as well as make it profitable for life insurance companies to underwrite TCLAPs. I would suggest a required minimum investment of $50,000 in the initial contribution year and $10,000 in subsequent years in which an individual decides to add funds to his/her TCLAP. These amounts would be applied to all of a household’s TCLAPs if more than one is owned.

6.  No Income Restriction

Unlike many tax credits, including the retirement savings contributions credit that’s subject to a maximum income limitation, this wouldn’t be the case for TCLAPs. Everyone, regardless of income level, needs to save for retirement. To the extent that there’s a vehicle for doing so that provides sustainable lifetime income protection from stock market corrections, we shouldn’t be limited by income from making that investment.

7.  Maximum Income Start Age

Since a TCLAP would be a double tax-favored plan with its built-in exclusion ratio and legislated-investment tax credit, a maximum income start age would need to be included in order for taxation on the nonexcluded portion of income payments to begin at a reasonable time from an IRS perspective.

Given the fact that most nonqualified DIAs provide for a maximum income start age of 85 to 95, I would recommend a maximum income start age of 75 for a TCLAP. Although most people would opt for a starting age approximating the traditional retirement age of 65, this would encourage purchase of multiple contracts with different starting ages to meet changing income needs in retirement.

8.  Minimum Income Start Age

To encourage individuals to defer their income start date for a reasonably long time to increase their periodic income payments and to discourage investment for the sole purpose of obtaining the tax credit, a minimum income start age would need to be legislated. I would recommend that the later of age 60 or 10 years from the initial purchase date be used for this purpose.

9.  Flexible Income Start Date

Flexibility is important since TCLAPS would be used for retirement planning. This includes the income start date since it’s a known fact that people often retire earlier than planned for various reasons. Likewise, there are situations where individuals either elect or are forced to extend their working years.

Recognizing this, subject to IRS’ maximum and minimum income start ages (see #7 and #8), accelerated and deferred income start dates could be provided for as follows:

  • Earliest income start date: 1 year after the last premium payment
  • Latest income start date: 5 years after the original income start date

10.  Larger Return of Premium Than DIA Contracts

When you purchase a traditional DIA or QLAC, you can include a return of premium provision in your contract in exchange for a small reduction in your periodic income amount. This provides for an income tax-free death benefit payable to one or more beneficiaries equal to the amount of investment in the contract in the event that the annuitant(s) die before income payments begin.

Once again, to encourage individuals to take advantage of TCLAPs, I would recommend that the return of premium be increased from the traditional 100% of investment amount to 125% of all investments made at least five years before the death of the annuitant or surviving annuitant in the case of joint annuitants. The purpose of the five-year rule would be to remove the incentive of individuals in declining health who wouldn’t normally purchase a DIA from obtaining a guaranteed 25% return on investment in a short period of time for their beneficiaries.

11.  Ability to Use Funds for Long-Term Care Protection Prior to Income Start Date

In the event that one or both annuitants, as applicable, meets one of the two traditional long-term care insurance benefit triggers, funds could be withdrawn from a TCLAP tax-free to pay for long-term care expenses. The two benefit triggers are:

  • Inability to perform two out of six of the activities of daily living (ADLs): bathing, continence, dressing, eating, toileting, and transferring
  • Cognitive impairment

A TCLAP owner would be able to take advantage of this provision after being a TCLAP owner for a specified period, say ten years. At that time, upon submitting periodic proof of meeting one of the two benefit triggers from a physician, a TCLAP owner would be paid a tax-free cash benefit of up to $5,000 per month to be used for long-term care expenses with a lifetime limit of 125% of the cumulative TCLAP investment amount.

Long-term care payments would be in lieu of receiving lifetime income beginning at the contractual income start date. If the annuitant dies before receiving 125% of the cumulative investment amount, the remainder would be paid to the individual’s beneficiaries as a tax-free death benefit.

12.  Required In-Force Income Illustrations and Income Benefit Statements

Before you invest in a DIA, your life insurance agent will prepare an illustration showing the amount of periodic income that you will receive beginning on a specified date assuming that you make your investment today. When permitted, the illustration can also include planned future additional premiums.

Given the fact that a TCLAP carrier would be required to accept additional premiums (See #2) and it’s important to know the amount of additional periodic lifetime income that you will receive, insurance companies would be required to provide in-force income illustrations upon request.

Confirmation and annual statements would also be required to show original and revised periodic income payment amounts resulting from additional contributions beginning at the contractual income start date.

Timely Idea

The proposed “Tax Cuts and Jobs Act” introduced by House Republicans on November 2nd includes no incentives for saving for retirement. While it generally retains the current rules for 401(k) and other retirement plans, it would repeal the rules allowable Roth IRA conversions and recharacterization of Roth IRA contributions as traditional IRA contributions.

A Tax Credit Longevity Annuity Plan, or TCLAP, would be a timely addition, and potential cornerstone, to any tax legislation. It could, and should, be passed as stand-alone legislation in the event that Congress is unable to agree on a comprehensive tax plan.

A TCLAP would have widespread appeal given its potential to create private pension plans similar to what our parents and grandparents enjoyed while also providing for long-term care benefits should this need arise. Throw in concerns about the long-term sustainability of Social Security and you’ve got the perfect storm for a TCLAP.

 

Categories
Annuities Deferred Income Annuities Retirement Income Planning

Are You Using This Tax-Favored Sustainable Income Strategy?

Do you own any investments that offer all of the following five benefits?:

  • Guaranteed lifetime income payment beginning at a future date chosen by you
  • Return of your investment if you die before income start date
  • Income payments can be insured for a specified number of years or until original investment has been returned
  • Nontaxable until income start date
  • 25% to 65% of each income payment excluded from taxation

There’s only one type of investment that offers all five advantages – a nonqualified, or nonretirement, deferred income annuity, or DIA. The first four benefits, which are individually and collectively very attractive as part of a retirement income planning strategy, are also provided by qualified, or retirement plan, DIAs. Unlike nonqualified DIAs, however, qualified DIA income distributions, including those from qualified longevity annuity contracts, or QLACs, are fully taxable.

Deferred Income Annuities vs. Single Premium Immediate Annuities

Benefit #5, exclusion of a portion of each income payment from taxation, is provided by nonqualified single premium immediate annuities (SPIAs) as well as DIAs. SPIAs can be an appropriate retirement income planning solution if you’re about to retire or are already retired and have an immediate need for sustainable lifetime income. With a SPIA, income distributions begin one month after purchase assuming a monthly periodic payment and no later than one year after purchase if you opt for annual payments.

Although they aren’t as prevalent in the marketplace, DIAs are a more appropriate retirement income planning strategy than SPIAs in most situations due to their deferred income start date. Whether you’re 40 years old and won’t be retiring for 25 years or you’re 65 and want to defer your income start date for five or more years, one or more DIAs can meet your need. Deferral of your income start date increases the amount of your periodic income payment since the insurance company will be making payments to you for a shorter period of time.

Exclusion of Portion of Each Income Payment from Taxation

DIAs and SPIAs offer a unique income tax advantage when they’re purchased as a nonqualified asset vs. inside a retirement plan. A portion of each income payment, generally in the range of 25% to 65%, is excluded from taxation.

How does this work? When you receive income payments from an annuity, in addition to earnings, you’re receiving a return of your premium, or investment. Any time that you receive a return of a nonqualified investment, this is considered to be your cost, or basis, and is nontaxable.

The amount of your income payment that’s nontaxable is determined using an “exclusion ratio.” This is calculated by dividing the investment in the annuity contract by the total expected lifetime payments in the case of a lifetime DIA. The latter is an actuarial calculation based on the life expectancy of you and a joint annuitant if applicable.

As an example, let’s say that you invest $100,000 in a lifetime DIA and your expected lifetime payments are $150,000. 66.7 percent ($100,000 divided by $150,000) of each payment will be tax-free until you receive $100,000. Once your payments total $100,000, 100% of each of your additional payments will be fully taxable.

Taxable Amount Determined by Purchase and Income Starting Ages

How is the taxable portion of each nonqualified DIA or SPIA payment determined? The younger you are when you purchase your DIA or SPIA and the longer you defer your income starting age in the case of a DIA, the greater the taxable percentage of each payment. Although, as stated earlier, you will increase the amount of each of your income payments with a DIA the longer you defer your income start date, you will also increase the taxable percentage.

The best way to illustrate this is with an example. Using actual payouts from a highly-rated life insurance company’s current lifetime deferred income annuity offering, the following is a table showing the taxable percentage of each monthly income payment assuming the following eight parameters:

  1. Male and female joint annuitants.
  2. Male is three years older than female.
  3. Male purchase age varies in increments of five years from 45 to 60.
  4. Female purchase age varies in increments of five years from 42 to 57.
  5. Male income starting age varies in increments of five years from 65 to 75.
  6. 100% of income continues upon death of first annuitant.
  7. Return of premium in the event of the death of both individuals prior to the income payout starting date whereby beneficiaries will receive 100% of the original investment.
  8. 10-year certain payout in the event that both individuals die after payments begin and before 10 years of payments have been distributed. The annuitants’ beneficiaries would continue to receive payments for the remainder of the 10 years.
Nonqualified Lifetime Deferred Income Annuity
TAXABLE INCOME PERCENTAGE
Male and Female Annuitants With Return of Premium and 10-Year Certain
               
  Purchase Age   Male Income Starting Age  
  Male Female   65 70 75  
  45 42   65.7% 69.6% 73.7%  
  50 47   58.4% 63.1% 68.1%  
  55 52   49.4% 55.3% 61.3%  
  60 57   38.3% 45.4% 53.0%  
               

Per the table, the taxable portion of each payment ranges from 38.3% to 73.7% (26.3% to 61.7% is nontaxable) depending upon purchase and income starting ages. Assuming an investment of $100,000, the monthly lifetime income payments range from $510 assuming a male purchase age of 60 and male income starting age of 65 to $1,707 assuming a male purchase age of 45 and male income starting age of 75. The annual lifetime and taxable payment amounts would be as follows for these two extremes:

Male purchase age of 60 and male income starting age of 65:

Total annual payments:                         $6,117
Total taxable annual payments:           $2,343 (38.3% x $6,117)

Male purchase age of 45 and male income starting age of 75:

Total annual payments:                         $20,487
Total taxable annual payments:           $15,099 (73.7% x $20,487)

Unique Tax-Favored Sustainable Income Strategy

If you have a sustainable income need and it isn’t immediate, one or more nonqualified deferred income annuities, or DIAs, can provide a unique tax-favored solution. While this post addresses lifetime DIAs, you can also purchase term, or period certain, DIAs that provide income streams for a specified number of months or years. This is a more sophisticated strategy that can be used to meet projected changing retirement income needs in different stages of retirement.

Finally, an inflation factor can be applied to DIA and SPIA income payments that will increase the amount of each payment each year. This will, however, reduce the initial payment amount accordingly.

Categories
Annuities Deferred Income Annuities Qualified Longevity Annuity Contract (QLAC) Retirement Income Planning

Replace Unpredictable RMDs with Secure Lifetime Income

I don’t know about you, however, whenever I’ve been required to do anything, I’ve never looked forward to it. This includes childhood chores like making my bed and mowing the lawn, taking prerequisite courses in college, and satisfying professional continuing education requirements.

It’s not enough that I’ve fulfilled, and continue to fulfill, numerous personal and professional demands. When I turn 70-1/2, I will be subject to yet another obligation that will be enforced for the rest of my life – Congress’ required minimum distribution rules.

Required Minimum Distribution Basics

Assuming that you have one or more retirement plans,  you need to take required minimum distributions (RMDs) from your plans each year beginning no later than April 1st of the year following the year that you turn age 70-1/2. Retirement plans include all employer sponsored plans, including traditional and Roth 401(k) plans, profit-sharing plans, 403(b) plans and 457(b) plans. Traditional IRAs, SEP-IRAs, and SIMPLE IRAs, as well as inherited traditional and Roth IRA accounts, are also subject to the rules.

RMD amounts change each year. They may increase or decrease depending upon two variables:  (a) the value of your retirement plan accounts on December 31st of the prior year, and (b) a life expectancy factor obtained from tables in IRS Publication 590-B. If you fail to withdraw your RMD by the applicable deadline, which is December 31st after the initial year, the amount that hasn’t been withdrawn is subject to an excise tax of 50%.

RMD Example

The main problem with RMDs is lack of predictability of projected annual withdrawal amounts compared to projected retirement income needs. RMDs are dependent upon retirement plan account values which, in addition to contributions, are dependent upon return.

Ignoring future contributions and potential withdrawals before age 70-1/2, let’s assume that you’re 50 years old, single, plan to retire at 67 when you will begin receiving Social Security benefits, and the value of your traditional IRA is $300,000. What will be the amount of your annual RMDs beginning at age 70-1/2? The answer to this question is that it depends upon the underlying investments in your IRA and annual rate of return.

Let’s assume that your traditional IRA appreciates 4% each year for the rest of your life. Per Exhibit 1, the value is projected to increase from $300,000 at age 50 to $684,000 at age 70. RMD’s are projected to increase from $26,000 beginning at age 71, to $35,000 at age 80, and to $44,000 at age 90 at which time they’re projected to level off and begin decreasing.

RMD Alternative

Since you’re planning for retirement and a long lifetime is a possibility, you want to receive a predictable and sustainable lifetime income stream to supplement Social Security while reducing investment risk. You discuss your goals and concerns with your retirement income planner. She recommends that you transfer your traditional IRA into a deferred income annuity (DIA) with a highly-rated life insurance company.

Assuming that you implement your advisor’s recommendation, you will receive monthly lifetime income of $4,059 beginning at age 70-1/2. There are additional guarantees built into your contract, including a return of premium, or investment, in the event that you die before age 70-1/2 and a 10-year certain payout if you die after your payments begin and before age 80-1/2.

Per Exhibit 2, you will receive income distributions totaling just under $49,000 a year from your DIA for the rest of your life beginning at age 70-1/2 in October, 2037. This amount is projected to initially exceed your annual RMD’s by $23,000, declining to an advantage of $13,000 at age 80 and $5,000 at age 89.

Fixed Income Annuities Exempt from RMDs

Fixed income annuities are exempt from RMDs since they have no cash value that can be used in a RMD calculation and the annuity payments are the same each year. Although they’re exempt from RMDs, payments from fixed income annuities held inside retirement plans must begin no later than age 70-1/2.

The income start date of qualified longevity annuity contracts (QLACs), a special kind of DIA designed for non-Roth retirement plan accounts, can be deferred to age 85. QLACs have a maximum allowable investment of 25% of the value of retirement accounts subject to a cap of $125,000.

RMDs vs. Fixed Income Annuity Payments

RMDs may not meet one’s needs since they’re calculated amounts based on fluctuating account values subject to underlying investment values and changing life expectancy factors. Annual calculations must be made and calculated amounts withdrawn by stipulated deadlines to avoid a 50% excise tax.

Fixed income annuity payments, on the other hand, are contractually fixed amounts that can be predetermined years before their start date to cover projected expenses beginning at age 70-1/2. Unlike RMDs, fixed income annuities aren’t subject to investment risk.

Fixed income annuity payments will often be greater than RMDs in early years. Annual differences will be dependent upon retirement plan annual investment returns. While investment accounts can be depleted, fixed income annuity payments will be paid for the remainder of one’s life. Best of all – they’re not required!

Categories
Annuities Deferred Income Annuities Retirement Income Planning

Is Cognitive Impairment Part of Your Retirement Income Plan?

The basic purpose of a retirement income plan is to develop tax-efficient strategies that are designed to provide predictable income streams to meet an individual’s or family’s financial needs during different stages of retirement.

A comprehensive plan should also include provisions for addressing potential life-changing experiences. One such event that’s generally associated with the latter stage of retirement is cognitive impairment.

As pointed out in the Center for Retirement Research of Boston College’s (CRR) January article, Cognitive Aging and the Capacity to Manage Money, most people who experience normal cognitive aging can manage their money in their 70s and 80s. This includes bill paying and evaluating an investment’s potential return relative to risk. Per the article, there are two situations that are problematic:  (1) financial novices and (2) individuals with cognitive impairment.

Financial Novices

While those with financial knowledge are generally able to manage their money in their later years, it’s much more challenging for individuals who haven’t acquired the requisite knowledge and experience needed to perform this task. These financial novices, who are often women, tend to be surviving spouses or individuals whose spouse has become incapacitated.

People who take on this role will either need informal help from a family member or formal assistance depending upon their depth of financial knowledge. The good news, according to the CRR study, is that most financial novices who aren’t cognitively challenged “will eventually gain enough knowledge to handle most financial matters without help.”

Individuals with Cognitive Impairment

Individuals in their 70s and 80s can often develop mild cognitive impairment (MCI) and ultimately severe dementia which is common in one’s 80s and 90s. According to a recent study cited in the CRR article, 95 percent of participants without any cognitive impairment were capable of managing their finances. This dropped to 82 percent of adults with MCI and 20 percent of adults with dementia.

Interestingly, individuals with cognitive impairment are often unaware that they’re not in control of their faculties, including their ability to manage their finances. Per the CRR article, “several studies have shown that people with MCI to full-blown dementia continue to feel confident about handling financial matters.” Given the fact that many of these individuals rely on a caregiver, this subjects them to the risk of financial abuse by the caregiver.

Simplify Investment Management

Although it can be challenging, surviving spouses and spouses of incapacitated individuals who don’t have the knowledge and experience of managing finances can eventually acquire the requisite information and skills to do so. It’s a much different story, however, for those with MCI and dementia.

Financial tools that are often used for retirement income planning include immediate and deferred fixed income annuities.  Both can fulfill the basic purpose of a retirement income plan as stated at the beginning of this article:  develop tax-efficient strategies that are designed to provide predictable income streams to meet an individual’s or family’s financial needs during different stages of retirement.

Immediate and deferred fixed income annuities can also eliminate the financial management challenges associated with cognitive impairment. Unlike a diversified investment portfolio that requires ongoing management, there are generally no significant financial decisions that need to be made with a fixed income annuity during one’s lifetime once an income start date is selected.

The income start date will vary depending upon the type of fixed income annuity as follows:

  • Immediate annuity: Generally one month after date of purchase
  • Deferred income annuity: Contractually set at the time of purchase with some contracts offering flexible start dates within a specified range before and after the contractual start date
  • Fixed index annuity with income rider: Totally flexible with most contracts requiring a one-year waiting period after the contract date

Develop an Extended Care Plan

Extended care should be a focal point of a retirement income plan. Strategies will vary with each household, depending upon medical history, marital status, potential extended family involvement, and financial knowledge and experience.

As discussed in my October 10, 2016 MarketWatch RetireMentors article, Make Sure You Have a Long-Term Care Plan in Place Before It’s Too Late, an extended, or long-term care, plan addresses various physical and mental changes that occur as we age. It includes specific steps that will be performed by family members and other individuals to manage the various changes when they occur. An extended care plan doesn’t necessarily have to include long-term care insurance.

Plan for Cognitive Impairment

Given the possibility and increasing occurrence of MCI and dementia, it’s important that informal and formal planning for these cognitive impairments begins long before they are likely to occur. As a general rule, the earlier that planning is done, the more options will be available to implement solutions to manage cognitive challenges when they materialize.

Categories
Annuities Deferred Income Annuities Retirement Income Planning

Income-Proof Your Aggressive Portfolio

With the Dow Jones Industrial Average (DJIA) crossing the elusive 20,000 barrier last Wednesday for the first time, a lot of people are excited about investing in the stock market. Never mind the fact that the DJIA has tripled in price from its low of 6,470 on March 6, 2009, increasing at a mind-boggling average annual rate of return of 40% for the last eight years.

If you have an aggressive portfolio and are within 15 years of retiring, you need to protect it from a sizable decline. When the Dow lost 52% in 17 months between October 1, 2007 and March 6, 2009, no one saw it coming. A lot of people who were planning on retiring in 2008 and 2009 were forced to postpone retirement.

Given the stock market’s unsustainable climb in the last eight years and the associated possibility of a significant market correction, it makes sense to insure your investment strategy. Assuming a portfolio of at least $500,000, one of the best ways that you can do this is by allocating 20% to 25% to one or more deferred fixed income annuities.

Aggressive Portfolio With No Income Protection Plan

Let’s assume that you’re 58, single, are planning to retire in 10 years, and you have an aggressive portfolio with a value of $1 million. Let’s take a look at two scenarios:

  1. Your portfolio declines 50% over the next 17 months.
  2. Your portfolio increases 10% over the next two years and then declines 50% over the next 17 months.

In scenario #1, the value of your portfolio has decreased from $1 million to $500,000 at the end of 17 months. In scenario #2, the value of your portfolio has increased from $1 million to $1,210,000 before decreasing to $605,000 17 months later.

You would probably agree that whether the value of your portfolio is 50% or 60% of its initial value, this doesn’t bode well for your retirement planning. It will take a long time for you to recover your loss. You’re also getting closer to your planned retirement date. Furthermore, your portfolio isn’t designed to provide you with any predictable retirement income.

Aggressive Portfolio With Income Protection Plan

Let’s suppose instead that you decide to insure your $1 million portfolio from a potential market decline by transferring 20%, or $200,000, into a deferred income annuity offered by a highly-rated life insurance company that will pay you lifetime income beginning when you retire in 10 years.  The life insurance company will also pay (a) a death benefit of $200,000 to your beneficiaries if you die before your income start date or (b) up to 10 years of payments to you and your beneficiaries if you die within the first 10 years after your income start date.

In scenario #1, the value of your remaining portfolio of $800,000 has decreased to $400,000 at the end of 17 months. In scenario #2, the value of your portfolio has increased from $800,000 to $968,000 before decreasing to $484,000.

By transferring $200,000 into a deferred income annuity, you have reduced your portfolio loss by $100,000 or $79,000, depending upon the scenario as follows:

  1. Scenario #1: Investment portfolio of $400,000 + deferred income annuity of $200,000 = $600,000 vs. $500,000 with no income protection plan
  2. Scenario #2: Investment portfolio of $484,000 + deferred income annuity of $200,000 = $684,000 vs. $605,000 with no income protection plan

In addition to reducing your portfolio loss, by transferring $200,000 into a deferred income annuity, you will receive annual income of approximately $20,000 for the rest of your life beginning at age 68 no matter what the stock market does. If the investment source is nonqualified funds, approximately 50%, or $10,000, of your annual income will be nontaxable.

Insure Your Portfolio

I believe that the 20,000 Dow is more than just a milestone given the breakneck pace at which it was achieved assuming that your reference point is March 6, 2009. It is instead a wake-up call for anyone with an aggressive portfolio who is within 15 years of retiring who doesn’t currently own any fixed income annuities. If this describes your situation, now is the time to income-proof your portfolio before the next major downturn when you’re that much closer to your planned retirement date.

Categories
Annuities Deferred Income Annuities IRA Retirement Income Planning

The 401(k) Unlevel Playing Field

With the Summer Olympics in Rio de Janeiro underway, sports are on my mind. There’s an unlevel playing field in the retirement planning world. Forgetting about defined benefit plans which are in a league of their own, 401(k) plans are the clear favorite for employees who want to save for retirement.

401(k) participants enjoy a decided advantage over those who don’t have access to these retirement plans when it comes to making contributions. This includes higher limits, greater ability to deduct contributions, ease of contributing to a Roth account, and potential employer matching contributions.

Higher Contribution Limits

The ability to accumulate a meaningful nest egg using traditional IRA and Roth IRA accounts is limited by several roadblocks that aren’t an issue with 401(k) plans. The most significant advantage of 401(k) plans over traditional and Roth IRAs is their contribution limit.

You can contribute up to the lesser of compensation or $18,000 to a 401(k) plan if you’re less than 50 years old. This is $12,500 greater than the maximum allowable IRA contribution of $5,500. The spread increases to $17,500 if you’re 50 or older, with limits of $24,000 and $6,500 for 401(k) and IRA contributions, respectively.

Greater Ability to Deduct Contributions

Pre-tax contributions to a traditional 401(k) are fully deductible. With traditional IRA plans, deductibility is potentially affected by participation in another retirement plan at work and marital status. If you or your spouse is covered by an employer retirement plan, then you must apply an income test based on your modified adjusted gross income, or “MAGI,” and tax filing status to calculate the amount of your deductible contribution.

Assuming that you’re covered by a retirement plan at work and you’re single, full deductions to traditional IRAs are allowed for MAGI of $61,000 or less, no deduction if MAGI is $71,000 or more, and a partial deduction is allowed for MAGI in between. The floor and ceiling for married filing jointly is $98,000 and $118,000, respectively.

If you aren’t covered by a retirement plan at work and you’re married and you file jointly, full deductions to traditional IRAs are allowed for MAGI of $184,000 or less, no deduction if MAGI is $194,000 or more, and a partial deduction is allowed for MAGI in between.

Ease of Contributing to a Roth Account

Employees may elect to make nondeductible contributions to a Roth account assuming it’s offered as part of their 401(k) plan. Furthermore, they may allocate contributions between traditional and Roth accounts as they see fit so long as their total contributions don’t exceed the IRS annual limits of $18,000 and $24,000 for those younger than 50 and 50 or older, respectively.

The ability to make Roth IRA contributions, like traditional IRA contributions, is limited by MAGI. If you’re single, Roth IRA contributions are allowed for MAGI of $117,000 or less, no contribution if MAGI is $132,000 or more, and a partial contribution for MAGI in between. The floor and ceiling for married filing jointly is $184,000 and $194,000, respectively.

Potential Employer Matching Contributions

Some 401(k) plans provide for employer matching contributions. A typical arrangement is the employer matches 50% of employee contributions up to the first 6% of salary.

As an example, suppose that your salary is $100,000, you contribute 10% to your 401(k) plan, and your employer matches your contributions using the typical arrangement. In addition to your contributions of $10,000 (10% x $100,000), your employer will contribute $3,000 (50% x 6% x $100,000) to your 401(k) account, resulting in total contributions of $13,000.

Importance of Retirement Income Planning

Whether you’re considering making contributions to a traditional 401(k), Roth 401(k), traditional IRA, or Roth IRA, you should do so within the context of a retirement income plan. A plan can be used to project the amount of after-tax income that you will receive from various sources beginning in a specified year for the duration of retirement.

You can prepare what-if scenarios to determine which types of retirement accounts, e.g., traditional vs. Roth 401(k), and annual contribution amounts are likely to optimize projected after-tax retirement income.  Your plan can, and should be, used to calculate gaps between projected retirement expenses and income. This in turn can be used to determine other types of non-retirement account investments and contribution amounts you should make to enable you to reduce the projected gaps and achieve your retirement income planning goals.

Deferred fixed income annuities should be included as part of your analysis since they’re designed for retirement income planning. Fixed income annuities, which generally aren’t offered in 401(k) plans, are the only investment that provides sustainable lifetime income. They also offer significant potential income tax savings and aren’t subject to IRS’ required minimum distribution rules when owned individually outside of a retirement plan.

While 401(k) plans enjoy many advantages on the front end, account values cannot be easily translated into projected retirement income streams. Whenever you invest in fixed income annuities, you know how much income you will receive each year beginning at a specified date with a given investment amount at the time of investment. This enables you to close projected income gaps with greater precision than is possible with 401(k) plans.

Categories
Annuities Deferred Income Annuities Retirement Income Planning

Period Certain is Cheap Insurance on SPIAs and DIAs

Single premium immediate annuities (SPIAs) and deferred income annuities (DIAs) are often used to provide sustainable lifetime income to replace a portion of employment income in retirement.  Both are tax-favored when nonretirement funds are used to purchase them since a portion of each income payment is a nontaxable return of principal.

The primary difference between a SPIA and a DIA is the annuity commencement, or income start, date. In the case of SPIAs, it is one month after purchase assuming a monthly payment frequency. With DIAs the income start date is a contractually defined date at least 12 months from the date of purchase. The longer the deferral period, the greater the periodic payment will be.

SPIA and DIA Income Payment Parameters

The periodic income payment amount for both SPIAs and DIAs is dependent upon several parameters, most of which are elective. These include:

  • Annuity type: single or joint life
  • Joint type in the case of joint life: reducing or non-reducing
  • Birth date(s)
  • Purchase date(s) (dates in the case of DIAs that allow multiple purchases)
  • Premium amount(s) (amounts in the case of DIAs that allow multiple purchases)
  • Income start date
  • Payment frequency, i.e., monthly, quarterly, etc.
  • Return of premium option in the case of DIAs
  • Income payment option

The last parameter, income payment option, can make a huge difference in the total amount of payments in the event of premature death. I’m using “premature death” to refer to death occurring prior to the annuitant receiving at least ten years of income payments.

Lifetime Income Payment Options

While DIAs can be purchased for a fixed term, e.g., five or ten years, DIAs and SPIAs are usually purchased for lifetime income. There are four lifetime income payment options to choose from when purchasing DIAs and SPIAs, all beginning on the annuity commencement date, with the following differences in the event of death:

  • Life only: Payments end.
  • Life with cash refund: Difference between the sum of lifetime income payments and premium payments is paid to the beneficiary(ies) in one lump sum.
  • Life with installment refund: Difference between the sum of the lifetime income payments and the premium payments will continue to be paid to the beneficiary(ies) until the sum of the income payments equals the premium payments.
  • Life with period certain: Income payments will be paid to the annuitant(s) and/or beneficiaries for a fixed number of years, usually 10 to 30, in the event that death occurs prior to the period certain.

The life only income payment option generally provides the largest periodic payment amount due to the fact that payments end upon death. Although this is the least risky option for an insurance company, it is the most risky for an annuitant.

As an example, suppose that you’re single and you purchase a SPIA that pays lifetime monthly income of $1,000 beginning one month from today. After receiving three months of payments, or a total of $3,000, you have a heart attack and die. The insurance company has fulfilled its obligations to you and there will be no additional payments.

Life Only vs. Life with Period Certain

Whether you’re considering a SPIA or a DIA, a life with period certain payment option is often the best choice. As previously stated, the number of years you can choose generally ranges from 10 to 30. The longer the period certain, the smaller will be the periodic payment amount.

While there will be a sizable reduction in the periodic payment amount with both the life with cash refund and life with installment payment options due to the guarantee that at least 100% of premium payments will be returned, it will generally be insignificant for a 10-year certain vs. life only payout. This is true whether you’re looking at a SPIA or a DIA.

To illustrate this, I prepared quotes for all of the SPIAs and DIAs available through my life insurance agency for a non-reducing joint life contract for a husband and wife issued in California on July 19, 2016 with a premium of $200,000 with the following additional parameters:

  1. SPIA: primary annuitant (male) birth date of April 20, 1946 (age 70), secondary annuitant (female) birth date of June 10, 1949 (age 67), and income start date of August 19, 2016 (one month from purchase date).
  2. DIA: primary annuitant (male) birth date of April 20, 1961 (age 55), secondary annuitant (female) birth date of June 10, 1964 (age 52), and income start date of July 19, 2031 (15 years from purchase date).

SPIA Example

The average monthly payment for 11 SPIAs with a life only payment option was $889.53, or $1.51 greater than the average monthly payment of $888.02 for the same 11 SPIAs with a 10-year certain payment option. Using the average monthly payment, ten years of payments totaling $106,562.40 ($888.02 x 12 months x 10 years) can be guaranteed by choosing a 10-year certain payout vs. potential payments of $0 if you instead choose the life only option and you die before the first payment is distributed.

DIA Example

When you purchase a DIA, in addition to the income start date, there’s one other important choice you need to make – purchase with or without a return of premium. Although I ran the DIA quotes with and without this additional parameter, the difference in monthly payment amounts was also insignificant.

Given the fact that (a) the income payment begins on the annuity commencement date and, (b) by definition, there will be a period of at least one year, and usually much more, between the purchase date and the income payment date whenever you purchase a DIA, your beneficiaries will receive nothing from the insurance company in the event that you, and another individual in the case of joint annuitants, die before the annuity commencement date unless you include a return of premium feature. Assuming this is part of your contract, your beneficiary(ies) will receive 100% of your premium payments in the event that you, and another individual in the case of joint annuitants, die before the annuity commencement date.

Whether or not a return of premium feature is included in your contract, the difference in monthly payment amount for a DIA is generally insignificant. I ran five DIA quotes with no return of premium and three with this option. The average monthly life only payment for the five without a return of premium was $1,416.98, or $13.76 greater than the average monthly payment of $1,403.22 for the same five with a 10-year certain payment option. The average monthly life only payment for the three that include a return of premium was $1,434.37, or $10.24 greater than the average monthly payment of $1,424.13 for the same three with a 10-year certain payment option.

Using the average monthly payment, ten years of payments totaling $168,386.40 ($1,403.22 x 12 months x 10 years) is guaranteed with no return of premium, and $170,895.60 ($1,424.13 x 12 months x 10 years) with a return of premium by choosing a 10-year certain payout vs. $0 if the life only option is chosen instead. In addition, the annuitants’ beneficiary(ies) would receive a return of the premium of $200,000 in the event both spouses die before the annuity commencement date of July 19, 2031 if a return of premium feature is included.

Four Takeaways

There are four takeaways from this post:

  1. Never choose a life only income payment option when purchasing SPIAs or DIAs unless you have no potential individual or charitable beneficiaries.
  2. There will be an insignificant reduction in the periodic payment amount with a 10-year certain vs. a life only payment option.
  3. While you, your spouse, and/or your beneficiaries may not receive income payments equal to 100% of your premiums in the event of premature death, the total payments will be much greater with a 10-year certain vs. life only payment option.
  4. Always include a return of premium feature when purchasing DIAs unless you have no potential individual or charitable beneficiaries .
Categories
Annuities Deferred Income Annuities Fixed Index Annuities Retirement Income Planning

Deferred Income Annuities Comparing More Favorably with FIAs with Income Riders

If you’re planning for retirement and you want to receive sustainable lifetime income beginning at a future date, deferred income annuities (DIAs) and fixed index annuities (FIAs) with income riders are potential suitable choices. These are the two types of deferred fixed income annuities that are sold by life insurance companies. The question is which one better meets your needs?

This isn’t an easy question to answer, especially if you don’t work with fixed income annuities on a regular basis. Furthermore, the answer to this question has become more complicated the last four years. While the choice is still driven primarily by one’s personal financial situation, and although FIAs with income riders continue to offer more features than DIAs (see FIAs with Income Riders vs. DIAs:  Which is Right for You? – Part 1 of 5), changes in the variables used to calculate income payouts from FIA riders combined with increased income rider charges have reduced the attractiveness of FIAs with income riders compared to DIAs.

Reduced Income Payouts

When I first began writing about, and working with, fixed income annuities in 2009, there were a handful of DIA products to choose from. Income payouts from the ones that were available were sometimes greater, and were often less, than those from FIAs with identical premium amounts, premium timing, and income start dates. The presence of an accumulation value with growth potential combined with a flexible income start date with a FIA vs. an optional pre-payout return of death benefit and a fixed income start date with a DIA often favored FIAs with income riders.

Beginning in 2011, in response to declining interest rates, life insurance companies began reducing income payouts on fixed income annuities. This is easy to do with DIAs since insurance companies simply declare a new payout rate.

FIA Income Rider Payout Reductions Less Transparent Than DIAs

FIA income payout reductions have been less transparent than DIAs due to the fact that income needs to be determined as part of a side “income account value” calculation that’s separate and apart from a FIA’s accumulation value, with multiple variables coming into play. Carriers can pick and choose the variables that they adjust to achieve desired income payout results.

Assuming no additional premiums or withdrawals prior to the income start date, the variables include the following:

  • Roll-up, or interest, rate
  • Type of roll-up rate, i.e., simple or compound
  • Roll- up rate term, e.g., 10 years, 20 years, age 85, etc.
  • Availability of premium bonuses
  • Inclusion/exclusion of premium bonuses in income account value calculation
  • Lifetime income withdrawal percentages

FIA and DIA income rider payouts have also been reduced in the last year in response to IRS’ revised mortality tables with longer life expectancies.

FIA Reduced Accumulation Values

While FIA accumulation values have generally increased in recent years as a result of positive performance of stock market indices to which FIA interest crediting is tied, the increases have been diluted by increased income rider charges resulting from increased income rider charge percentages beginning in 2011. This is in addition to increasing income rider charges resulting from annual income account value increases.

Charges that were in the 0.65% to 0.75% of income account value range increased to 0.95% or more in some cases. Although it doesn’t affect income payouts, increased rider charges result in erosion of a FIA’s accumulation value and death benefit.

Furthermore, the income rider charges for some FIA income riders have the potential to double after a specified period of time. With one product, the carrier will declare a new income rider charge in year eleven with a maximum charge of double the original income rider charge percentage if you want to extend the application of the roll-up rate to the income account value for an additional ten years beyond the first ten years of the contract. Although you will receive a higher income payout by doing this, the accumulation value of your contact will be adversely affected.

Income Optimization is Still the Name of the Game

As stated at the beginning of this post, DIAs and FIAs with income riders are potentially suitable choices if you’re planning for retirement and you want to receive sustainable lifetime income beginning at a future date. While income payouts aren’t as generous as they were four years ago, income optimization is still the name of the game.

Income optimization needs to be driven by your targeted income start date and projected ongoing retirement income needs. Income payouts beginning at different ages with different DIAs and FIAs should be compared. Whereas one product might have the highest income payout beginning at age 65, this may not be the case if the income start date is deferred to age 75.

A DIA vs. FIA comparison should be done on an after-tax basis for nonretirement accounts. DIAs apply an “exclusion ratio” to the income payout for these types of accounts that results in the exemption of the portion of payouts attributable to a return of principal from taxation.

FIAs often have the edge In situations where you’re not certain when you will need your income due to their flexible income start date. Multiple DIAs with different income start dates can also provide income start date flexibility. Although most DIAs have a fixed income start date, some offer flexibility, allowing income to begin within a specified number of years before or after their contractual start date.

Side-by-side comparisons of FIAs with income riders vs. DIAs should always be performed in order to determine which one makes the most sense in a particular situation. Combinations of multiple FIAs and/or DIAs with difference income start dates and premium amounts can be used to dovetail with projected retirement expense needs while also providing diversification.

Categories
Annuities Deferred Income Annuities Retirement Income Planning

Optimize Deferred Income Annuity Pre- and Post-Income Start Date Payout

Deferred income annuities, or DIAs, are one of the two types of deferred fixed income annuities sold by life insurance companies, the other being fixed index annuities, or FIAs, with income riders. DIAs are the simpler of the two products to understand and are often the most suitable choice in many situations.

A DIA is an annuity from which a periodic payout begins at least 12 months after the date of purchase in exchange for a lump sum or series of periodic premiums. The payout can be for a term certain or lifetime, depending upon the terms of the annuity contract.

Optimize Income Payment for Desired Start Date with Smallest Investment

Assuming that deferred sustainable lifetime income is your objective, you should always optimize your periodic income payment, using the smallest premium, or investment amount, to receive the largest payout beginning when you will need your income whenever possible. Equally important, you should only work with highly-rated life insurance companies that specialize in fixed income annuities.

Optimization of income needs to be driven by your targeted income start date and projected ongoing retirement income needs. Although most DIAs have a fixed income start date, some do offer flexibility, allowing income to begin within a specified number of years before or after their contractual start date. Multiple, or laddered, DIAs with different income start dates can also provide you with income start date flexibility.

Balance Income Optimization with Death Benefit Guarantees

Income optimization needs to be balanced with death benefit guarantees. There are two types, both of them optional:  pre-income payout and post-income payout. A maximum periodic income payment will always be generated when there are no pre- or post-payout death benefit guarantees. Likewise, pre- and post-income payout options will result in reduced payments when they’re added to a DIA contract.

If you purchase a DIA at age 50 with lifetime income beginning at age 65 with no pre- or post-payout death benefit guarantees and you die at 64, the life insurance company will retain 100% of your investment plus all earnings to date. There will be no payout to your beneficiaries. If you have absolutely no heirs or charities to which you want to leave assets or income, this may not be important to you.

Pre-Income Payout Death Benefit

If there are potential beneficiaries, you should always include a pre-payout death benefit as part of your DIA contract.  This is also known as a “return of premium” feature due to the fact that the amount of the death benefit will equal the amount of premiums paid.

While your beneficiaries won’t receive any earnings, they will at least receive the amount that you invested in your annuity contract in the event that you die before receiving any income payments. Your income payment will generally be slightly smaller if your contract includes a return of premium feature.

Post-Income Payout Death Benefit

Assuming that you survive to your income start date, your periodic income payment will begin and will continue until the end of your life or your life and your beneficiary’s life if you have a joint and survivor annuity. This will generally be the case for married couples.

Whether you have a single- or joint-life annuity, you can include an optional post-income payout death benefit guarantee that will ensure that you and your beneficiaries will receive a minimum amount of income from your contract.  This is typically accomplished with a term certain of five to thirty years.

Similar to a pre-income payout death benefit, inclusion of a post-income payout death benefit will reduce the periodic payout amount that you will receive. The amount of the reduction is usually relatively small when you compare the total minimum guaranteed payout with a post-income payout guarantee to one without.

I recently analyzed and compared DIA illustrations for a married client that included a return of premium feature. One illustration also included a 10-year certain post-income payout and the other was for 20-years certain. The following are the annual and guaranteed minimum joint-life payouts beginning 13 years from purchase assuming an investment of $300,000:

10-Year
Certain
20-Year
Certain
Annual Income $34,457 $32,693
Guaranteed Minimum Payments $344,570 $653,860

Given the fact that my clients have two pre-college age children and the annual income with the 20-year certain payout of $32,693 is only $1,764 less than the 10-year certain payout amount of $34,457 and the guaranteed minimum payments of the 20-year payout of $653,860 are $309,290 greater than the payouts of $344,570 with the 10-year certain payout, the 20-year certain payout was an obvious choice.

In summary, when evaluating deferred income annuities, while optimization of income payouts is the primary goal, this needs to be balanced with optional pre- and post-income payout death benefit guarantees. This will ensure a maximum payout for the annuitants as well as for potential beneficiaries.

Categories
Annuities Deferred Income Annuities Longevity Insurance Qualified Longevity Annuity Contract (QLAC)

Don’t Defer Your QLAC Purchase

I was recently asked by CNBC personal finance writer Tom Anderson, who was writing a story on qualified longevity annuity contracts, or QLACs, “What are the biggest mistakes clients make when buying QLACs?” My answer, which was quoted in Tom’s September 9th An Option for Those Who Fear Outliving Their Money article, was not purchasing a QLAC soon enough.

A Special Type of Annuity

QLACs are a special type of deferred income annuity, or DIA, that was approved by IRS in July, 2014. There are four things that distinguish QLACs from DIAs:

  • They can only be held in traditional IRA and retirement plan accounts.
  • They circumvent IRS’ required minimum distribution, or RMD, rules mandating annual age-based withdrawals beginning at age 70-1/2.
  • Lifetime distributions must begin at a specified date no later than age 85.
  • Purchase amount is limited to the lesser of $125,000 or 25% of combined traditional IRA and retirement plan values.

QLACs Aren’t for Everyone

QLACs aren’t for everyone. This is reflected in my quote, “The biggest mistake a client can make when buying a QLAC, assuming the client doesn’t need the income before 75 or so, is not purchasing a QLAC soon enough.”

If you anticipate that you can’t afford to postpone the start date for receiving income from a portion of your retirement plans until 75 or later, then a QLAC doesn’t make sense. You can still purchase a DIA in your traditional IRA or retirement plan, however, your income must begin by age 70-1/2.

Four Decisions

If you would like to carve out a portion of your traditional IRA and retirement plans in exchange for a deferred lifetime income stream, in addition to choosing beneficiaries and the life insurance company from which you will purchase your QLAC, there are four decisions you need to make:

  1. Subject to the investment limitation of the lesser of $125,000 or 25% of traditional IRA and retirement plan values, how much do you want to invest?
  2. Subject to the maximum deferral age of 85, when do you want to begin receiving income?
  3. Which pre- and post-income payout options should you choose, e.g., return of premium (pre-income payout option), life only, life with cash refund, 10-year certain, etc.?
  4. When should you invest?

Purchase Sooner Than Later

What is obvious to most people is the longer you defer your income start date, the greater the amount of your monthly lifetime income. If you begin receiving income at age 85 vs. 75, the insurance company will increase your monthly income significantly since they will be making payments to you for ten less years.

Something that’s not necessarily intuitive for a lot of people is the fact that your monthly payout will also increase if you purchase your QLAC sooner than later.  There’s no minimum purchase age limitation for QLACs.

As an example, assuming that you want your income payout to begin at age 80, your annual payout as a percentage of your investment will be 15% if you purchase at age 70 and will increase to 25% if you do so instead at age 60 with one of the QLACs available from a highly-rated carrier.  Assuming an investment of $125,000, this translates to annual income of approximately $19,000 if you purchase at age 70 vs. $31,000, or $12,000 more, if you do so at age 60.

Subject to availability in individual retirement plans, I would encourage most people who are at least 45 years old and have at least $500,000 in traditional IRAs and retirement plans to transfer $125,000 into a QLAC in order to secure a sustainable lifetime income stream, remove this amount from future stock market volatility, and maximize payout. Additional purchases can be made if IRS increases the QLAC investment limitation.

There’s an important caveat to keep in mind.  Even though your income payment will be slightly less, you should always purchase a QLAC with a pre-income commencement death benefit, or “return of premium” feature. Assuming this is part of your QLAC and you and your spouse, if married, both die before your income start date, your beneficiaries will receive a death benefit equal to your purchase, or premium, amount.

As I was also quoted in the CNBC article, “They (QLACs) will increase in popularity as more carriers offer them. I believe that higher net worth individuals with large IRA balances will gravitate toward them if the current investment limitation of $125,000 is meaningfully increased.”