When you buy a house, typical financing is a mortgage equal to 80% of the purchase price. This enables you to purchase a much more expensive home than you would otherwise be able to do without the mortgage. The goal is to increase your equity in the property over time through a combination of paying down the mortgage and appreciation.
The foregoing strategy is a classic example of using leverage. Why not do the same with your investment assets that are being accumulated for retirement?
Accumulation of Assets is the First Step
When you plan for retirement, you need to design a plan that will enable you to have enough after-tax income to pay for projected inflation-adjusted expenses for the rest of your life. Although accumulation of assets is essential for this purpose, it is only the first step.
A retirement plan isn’t complete unless it includes strategies for converting investment assets into income. The strategies need to leverage assets to provide an optimal amount of annual after-tax income that will match expenses during different phases of retirement.
How to Leverage Assets for Optimal Income
Leveraging assets for optimal income is a two-step process. The first step is asset placement. It begins in the asset accumulation phase, with the payoff coming in retirement.
What is asset placement? Asset placement is the positioning of investment assets so that lifetime distributions from those assets can be maximized after taking into consideration funding and distribution income tax consequences.
As discussed in my What’s Your $1 Million Payday Really Worth? MarketWatch article, the answer to the question, how long will your $1 million last, will be quite different depending upon whether you’re taking withdrawals from taxable, tax-deferred, or tax-free investment accounts.
While it’s tempting to make pre-tax contributions to a traditional 401(k) plan, greater after-tax retirement withdrawals are possible using a Roth 401(k). Although not as tax-efficient as a Roth 401(k), placement of a portion of investment assets in nonretirement accounts can also maximize distributions in retirement.
The second, and key, step in leveraging assets for optimal income is sustainability. When you retire, can you count on income being paid for the rest of your life?
The answer is generally “yes” if you’re talking about Social Security or a pension. How do you create sustainable lifetime income using investment assets? Fortunately, there’s a long-standing, highly-regulated solution that’s been successfully used for this purpose by several generations of retirees.
Fixed income annuities, with their unique mortality credits, leverage assets to provide for an optimal level of income that’s guaranteed to be paid by the issuing life insurance carrier for a defined period of time, typically life. Premiums paid by those who die earlier than expected enable the insurance company to guarantee and make larger income payments to all annuitants. This hedges longevity risk and creates a highly competitive, if not unbeatable, return.
Asset Leveraging Example
To illustrate the leveraging power of a fixed income annuity, especially a nonqualified fixed income annuity, let’s assume that Sam, a 65-year-old male, is deciding whether to invest $200,000 in a single-premium immediate annuity (SPIA) with a 10-year certain payout or a managed investment account. Sam also needs to decide if he should make the investment using funds from his traditional 401(k) plan or from nonqualified money.
Other assumptions include the following:
- Sam can purchase a SPIA from a highly-rated life insurance carrier that will pay him monthly income of $1,108.18, or annual income of $13,298.16 for the rest of his life beginning one month after date of purchase.
- An exclusion ratio of 72.2% would apply to the SPIA if purchased with nonqualified funds.
- Sam will withdraw $1,108.18 per month from a managed investment account.
- If Sam’s investment is made using 401(k) plan funds, the annual distribution of $13,298.16 is projected to exceed Sam’s annual required minimum distribution (RMD) amounts beginning at age 70-1/2.
- Sam will use 100% of his after-tax distributions to pay for various expenses.
- The ordinary income tax rate that would be applied to 401(k) plan and taxable nonqualified SPIA income is 30%.
- An income tax rate of 25% would be applied to nonqualified managed investment account distributions.
- The net rate of return after management fees on the managed investment account is 4%.
Traditional 401(k) (See Exhibit 1)
Let’s assume that the proposed investment is being made using traditional 401(k) plan funds. Sam’s annual distributions would be $13,298.16, with after-tax distributions of $9,308.71 whether he invests in a SPIA or a managed investment account.
Sam’s annual distributions of $13,298.16 from his managed investment account would equal 6.65% of the original value of the account of $200,000. Sam’s first-year distributions would exceed the projected earnings of $7,468.07 by $5,830.09, reducing the value of Sam’s 401(k) to $194,169.91 at the end of year 1. Sam’s 401(k) is projected to be depleted at Sam’s age 87 at which time his projected cumulative after-tax distributions would be $205,023.63.
Sam’s projected cumulative after-tax distributions from his SPIA would equal those from his managed investment account when the latter is depleted. Sam would continue to receive his monthly distributions of $1,108.18 from his SPIA for the rest of his life.
While Sam’s SPIA hedges against longevity risk, the managed investment account in this example would be a better alternative if Sam dies between age 75 and 85. Sam’s SPIA distributions will continue to be paid to his beneficiaries if he dies between age 65 and 74 due to the 10-year certain provision.
Sam’s SPIA distributions will no longer be paid if he dies after age 74. Sam’s beneficiaries would receive the remaining value of his traditional 401(k) which is projected to be approximately $130,000 at Sam’s age 74 and decrease to approximately $14,000 at Sam’s age 85.
Although he would receive slightly less monthly income, Sam could insure against the risk of dying between 75 and 85 by purchasing a SPIA with a 20- vs. 10-year certain period. Sam’s monthly income with a 20-year certain SPIA would be approximately $100 less than with a 10-year certain SPIA.
Nonqualified Account (See Exhibit 2)
As previously discussed, asset placement is the first step in leveraging assets for optimal retirement income. Let’s suppose that the funds for Sam’s investment are held in a nonretirement, or nonqualified, investment account. In this case, Sam’s SPIA would enjoy favorable income tax treatment compared to his managed investment account due to the availability of an “exclusion ratio” with a nonqualified SPIA.
The ratio of 72.2% in this example represents the nontaxable portion of each income payment. This is considered to be a return of Sam’s original investment based on his life expectancy when he invested in the SPIA at age 65 and the 10-year certain payout.
This results in a reduction of the effective income tax rate on Sam’s distributions from 30% to 8.34%. This would reduce his annual income tax liability from $3,989.45 if the SPIA is held in a traditional 401(k) to $1,109.07 if purchased using nonqualified funds.
Sam’s SPIA cumulative after-tax distributions are projected to be $280,349.15, or $60,680.98 greater than those from his managed investment account of $219,668.17 at age 87 when the latter is projected to be depleted. The managed investment account in this example would be a better choice if Sam dies between 75 and 82. During these years, the remaining projected balance of Sam’s managed investment account reduced by the projected additional after-tax cumulative distributions from the SPIA vs. the managed investment account would be positive.
Asset Placement and Income Sustainability – A Winning Combination
A retirement plan isn’t complete unless it includes strategies for converting investment assets into an optimal amount of annual after-tax income that will match your expenses during different phases of retirement. Leveraging investment assets through asset placement and sustainable income strategies using fixed income annuities will generally increase your ability to achieve this goal. Choice of specific strategies will be dependent upon preparation of a detailed financial analysis, as well as assumptions used in the analysis.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.