Invest in DIA to Fund LTCI Premiums When Retired – Part 2 of 4

Invest in DIA to Fund LTCI Premiums When Retired – Part 2 of 4

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Last week’s post discussed the use of a deferred income annuity (“DIA”), commonly referred to as longevity insurance, to fund long-term care insurance (“LTCI”) premiums during retirement. Similar to a fixed index annuity (“FIA”) with an income rider, in exchange for an initial investment, or premium, you’re entitled to receive a lifetime income beginning at least a year from the date of purchase.

As noted in last week’s post, there are five important differences between FIA’s with income riders and DIA’s that will influence which retirement income planning strategy is preferable for funding LTCI premiums in a given situation. These differences are as follows:

  1. Income start date flexibility
  2. Income increase provision
  3. Income tax consequences
  4. Investment value
  5. Death benefit

The first three distinctions are explained below. Part three will discuss the fourth and fifth differences. Part four will present a sample case to illustrate the use of a DIA vs. a FIA with an income rider to fund LTCI premiums during retirement.

Income Start Date Flexibility

FIA’s with income riders are known for their flexibility when it comes to their income start date. Income can typically be withdrawn beginning one year from the initial issue date with no time limit after that. The lifetime income payout will generally increase the longer you wait to begin your withdrawals as a result of potential increases in the income base and withdrawal percentages.

Unlike FIA’s, DIA’s generally aren’t flexible when it comes to the income start date. With most DIA’s, you’re tied to a specified payout at a specified start date at the time of investment.

Income Increase Provision

Although DIA’s generally have a fixed income start date, an annual inflation factor can be applied to the income payout to result in increasing annual payments. A greater premium, or investment, is required for this feature.

While the annual lifetime income payout will generally increase the longer you wait to begin your withdrawals with a FIA, the income amount generally won’t change once you turn on your income. In other words, there’s inflation protection built into FIA income riders only up until the time that you begin taking income withdrawals.

Income Tax Consequences

If retirement plans such as 401(k)’s or traditional IRA’s are the source of premium payments, then 100% of withdrawals from DIA’s and FIA’s will generally be taxable as ordinary income. Consequently, it doesn’t matter if the source of funds for LTCI premium payments is a FIA with an income rider or a DIA since taxation will be identical.

Whenever possible, nonretirement funds should be used to pay LTCI premiums. Here’s where DIA’s have the edge, especially during the early years. DIA payouts are considered to be an annuitization of the investment. Part of each payment through one’s life expectancy is deemed to be principal and interest. Any payments received thereafter are fully taxable.

Since only the interest portion is taxable and a large part of each payment is often classified as principal over the course of one’s life expectancy, DIA distributions receive tax-favored treatment.

When you take income withdrawals from FIA’s, on the other hand, you aren’t annuitizing your investment. Instead, “last-in first-out,” or “LIFO,” taxation is applied to your withdrawals. This means that 100% of your initial withdrawals will be taxed until all interest is recovered with subsequent withdrawals received tax-free as a return of principal.

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