Deferred income annuities (DIAs) have been getting a lot of attention since the Treasury and IRS finalized a regulation in July, 2014 blessing the use of qualified longevity annuity contracts, or “QLACs.” A QLAC is a DIA that’s held in a qualified retirement plan such as a traditional IRA with a lifetime income start date that can begin up to age 85. It’s subject to an investment limitation of the lesser of $125,000 or 25% of one’s retirement plan balance.
Fixed Income Annuity Hierarchy
For individuals concerned about longevity who are looking for a sustainable source of income they can’t outlive, fixed income annuities are an appropriate solution for a portion of a retirement income plan. There are three types to choose from:
The overriding goal when choosing fixed income annuities is to match after-tax income payouts to periodic amounts needed to pay for specified projected expenses using the least amount of funds. Immediate annuities, with a payout that begins one month after purchase date, are appropriate for individuals on the cusp of retirement or who are already retired. DIAs and FIAs with income riders, with their built-in deferred income start dates, are suitable whenever income can be deferred for at least five years, preferably longer.
Assuming there isn’t an immediate need for income, a deferred income strategy is generally the way to go when it comes to fixed income annuities. This includes one or more DIAs or FIAs with income riders. Which should you choose?
As a general rule, DIAs and FIAs are both qualified to fulfill the overriding income/expense matching goal. Both offer lifetime income payouts. If your objective is deferred lifetime sustainable income, DIA and FIA with income rider illustrations should be prepared to provide you with an opportunity to compare income payouts.
DIAs can also be purchased for a specified term of months or years. This can be important when there are projected spikes in expenses for a limited period of time.
DIAs may also be favored when used in a nonretirement account since a portion of their income is treated as a nontaxable return of principal. Finally, if you’re looking to defer the income start date beyond the mandatory age of 70-1/2 for a limited portion of a traditional IRA, a QLAC, which is a specialized DIA, may be an appropriate solution.
Let’s suppose that you’re a number of years away from retirement and you’re not sure when you want to retire or how much income you will need each year. A DIA may not be your best choice since you lock in a specified income start date and income payout at the time of investment with most DIAs.
FIA with Income Rider Features
FIAs with income riders hold a distinct advantage over DIAs when it comes to income start date flexibility. Unlike a DIA, there’s no requirement to specify the date that you will begin receiving income when you purchase a FIA.
The longer you hold off on taking income, the larger the periodic payment you will receive. Furthermore, there’s no stipulation that you ever need to take income withdrawals. This is ideal when planning for retirement income needs ten or more years down the road.
For individuals not comfortable with exchanging a lump sum for the promise of a future income stream beginning at a specified date, i.e., a DIA, a FIA with its defined accumulation value and death benefit, offers an attractive alternative assuming similar income payouts. While an optional death benefit feature can be purchased with a DIA to provide a return of premium to one or more beneficiaries prior to the income start date, this will reduce the ongoing income payout amount.
A FIA also has a defined investment, or accumulation, value that equates to a death benefit. Unlike with most DIAs, flexible-premium FIAs offer the ability to make additional investments that will increase income withdrawal amounts in addition to the investment value.
Some FIAs offer a premium bonus that matches a limited percentage, e.g., 5%, of your initial, as well as subsequent, investments for a specified period of time. The accumulation value is also increased by contractually-defined periodic interest credits tied to the performance of selected stock indices.
Finally, a FIA’s accumulation value is reduced by withdrawals and surrender and income rider charges. Any remaining accumulation value is paid to beneficiaries upon the death of the owner(s).
A comprehensive retirement income plan is a prerequisite for determining the type(s), investment and income payout timing, and investment amounts of fixed income annuities to match after-tax income payouts with projected expense needs assuming that longevity is a concern. If you don’t have an immediate need for income and your objective is lifetime sustainable income, DIA and FIA with income rider illustrations should be prepared to provide you with an opportunity to compare potential income payouts.
With their ability to match a spike in expenses for a limited period of time, term DIAs offer a unique solution. When it comes to lifetime income payouts, FIAs with income riders, with their flexible income start date and accumulation value and associated built-in death benefit, are, in effect, a DIA on steroids.
Given the foregoing advantages and assuming similar income payouts, FIAs with income riders generally offer a more comprehensive solution for fulfilling sustainable lifetime income needs, with the possibility of a larger death benefit. A potential exception would be when investing in a nonretirement account for higher tax bracket individuals subject to one’s preference for a flexible income start date and accumulation value/death benefit in a particular situation.
Last, but not least, all proposed annuity solutions should be subjected to a thorough due diligence review and analysis of individual life insurance companies and products before purchasing any annuity contracts.
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.