Annuities Fixed Index Annuities Income Tax Planning

Annuitization Tax Treatment of Nonretirement Distributions

Per last week’s post, there are four things that you don’t receive when you purchase an income rider with a fixed index annuity that are associated with fixed income annuities. The first three, i.e., annuitization, immediate payments, and ability to receive payments over a fixed period, were discussed in last week’s post. The fourth thing – annuitization tax treatment of nonretirement distributions – is the subject of this week’s post.

Before we discuss tax treatment of distributions, I want to talk briefly about taxation of annuities during the accumulation stage before any distributions are made. Similar to IRA’s and other qualified retirement plans, unless they’re immediately annuitized, all annuities, including fixed income annuities, enjoy tax-deferred growth. That is, until distributions are taken, there’s no taxation. This is true whether the annuity is held within a nonretirement account, a traditional IRA or other qualified plan, or a Roth IRA.

Once payments begin, they’re subject to taxation. Income tax treatment is dependent upon the type of account or plan in which the annuity is held. The remainder of this post will discuss income tax treatment of payments as it pertains specifically to fixed index annuity income riders.

At the two extremes when it comes to taxation are traditional IRA’s and Roth IRA’s. If held within a traditional IRA or other qualified plan, all distributions, other than those deemed to come from nondeductible contributions, are taxable as ordinary income. For fixed index annuities held within a Roth IRA, and assuming that the investment has been held for at least until the greater of five years or age 59-1/2, none of the distributions are taxable.

Taxation of distributions from annuities held within nonretirement accounts, on the other hand, uses a hybrid approach. Furthermore, the tax treatment is different depending upon whether you’re annuitizing an annuity vs. receiving payments from a fixed index annuity income rider.

When you annuitize a nonretirement fixed income annuity, part of each payment is considered to be a return of principal and part is deemed to be earnings. The principal portion is nontaxable and the earnings are taxable as ordinary income. Once the total amount of the investment in the contract is recovered, all future payments are fully taxable.

Per the “Annuitization” section of last week’s post, income rider payments are deemed to be withdrawals vs. annuitization of a fixed index annuity contract. This is an important distinction when it comes to income tax treatment of nonretirement distributions. As withdrawals, last-in first-out, or “LIFO,” tax treatment applies for investments made after August 13, 1982. This means that the first money that comes out is taxable as ordinary income similar to distributions from contributory IRA’s. Once all of the earnings have been received, all future payments are considered to be a return of investment, and, as such, are nontaxable.

In summary, the fourth and final thing that you don’t receive when you purchase an income rider with a fixed index annuity is annuitization tax treatment of nonretirement distributions. This is initially less favorable compared to annuitization since distributions are fully taxable until all earnings have been received. After this occurs, future distributions are nontaxable vs. taxable as ordinary income once the investment in the contract has been recovered when you annuitize an annuity.

Annuities Deferred Income Annuities Retirement Income Planning

What Tools Does Your Financial Advisor Have in His or Her Toolbox?

I want to wish all of my readers a very Happy New Year! The theme of the last eight blogs, beginning with the November 9th post, Using Fixed Income Annuities to Build Your Income Portfolio Ladder, through last week’s post, The Thrive® Income Distribution System – A Revolutionary Retirement Income Planning System, was creating and optimizing retirement income with fixed income annuities.

To summarize, the strategic implementation of single premium immediate (“SPIA’s”) and deferred income (“DIA’s”) annuities by trained and experienced professionals as part of a comprehensive retirement income plan can be a powerful solution for generating guaranteed (subject to individual insurers’ claims-paying ability), inflation-protected, and tax-efficient income that, when combined with other sources of income, e.g., Social Security, is designed to match a client’s projected retirement income needs.

If you’re within ten years of retiring or if you retired within the last ten years, you may be wondering why your financial advisor hasn’t talked to you about any of the strategies discussed in the last eight blogs. Rest assured, you’re not alone. A 2009 Fidelity study found that 83% of investors between the ages of 55 and 70 who are working with a fee-based adviser believe it’s more important for them to generate guaranteed (subject to individual insurers’ claims paying ability) income for retirement than to deliver above-average returns.

In the same study, 97% said protecting against market volatility is the most critical role that advisors can play today, and 86% said they would be interested in a product with monthly guarantees for life. So why isn’t your financial advisor talking to you about these types of products?

There’s a strong likelihood that if your financial advisor isn’t discussing fixed income annuities with you, he or she probably isn’t licensed and trained to do so. While your financial advisor may be an excellent retirement asset planner, he or she may not be equipped with the necessary tools to design and implement a comprehensive retirement income planning solution for you.

The purchase of annuities as part of a retirement income planning solution involves a technical process that requires the expertise of a trained and experienced professional, in this case, a retirement income planner. As stated in the December 21st post, Designing Your Income Annuity Plan, the design of an income annuity plan is complex and annuities should never be purchased as stand-alone products when used as part of a retirement income planning solution. As evidence of the technical nature and complexity of this area, 18 out of 56, or one-third, of the terms currently in the Glossary of Terms section of Retirement Income Visions™ were added in conjunction with the last eight posts.

As explained in The Retirement Planning Paradigm Shift – Part 2, retirement planning is undergoing a paradigm shift. Instead of relying on retirement asset planning as a solution for both the accumulation and withdrawal phases of retirement, people are beginning to recognize, understand, and appreciate the need for, and value of, employing retirement income planning strategies during the withdrawal phase. The understanding of this paradigm shift is the first step that is necessary for a financial advisor to be successful in the retirement income planning arena.

Once a financial advisor understands the difference between retirement asset vs. retirement income planning, and the importance of using retirement income planning strategies for clients approaching or entering retirement, he or she then must acquire the requisite tools to practice as a retirement income planner if not already possessed. To begin with, in order to sell any type of annuity, an individual must have a valid life/health agent insurance license issued by the state in which he or she would like to sell annuities. As with all professional licenses, there are initial and ongoing educational requirements to obtain, and maintain, an insurance license.

With any profession, while education provides the foundation, experience, in this case, in retirement income planning, including the design and implementation of retirement income planning strategies, is essential. The knowledge and experience obtained from having other related professional licenses and credentials, such as the CERTIFIED FINANCIAL PLANNER™ designation, CPA, or CPA Personal Financial Specialist (PFS), can also prove to be quite valuable in the design and implementation of a retirement income plan.

If you’re within ten years of retiring or if you retired with the last ten years, you may want to take a peek into your financial advisor’s toolbox to see if he or she has the tools to design, implement, and maintain a retirement income plan for you that will provide guaranteed (subject to individual insurers’ claims-paying ability), inflation-protected, and tax-efficient income that, when combined with other sources of income, e.g., Social Security, is designed to match your projected retirement income needs.

Annuities Deferred Income Annuities Retirement Income Planning

Lifetime Annuity Payout – Watch Out!

Using Fixed Income Annuities to Build Your Income Portfolio Ladder introduced two types of fixed income annuities: single premium immediate annuities, or “SPIAs,” and deferred income annuities, or “DIAs.” As stated in that blog post, while the use of SPIAs is widespread, DIAs are currently offered by only a handful of life insurance companies.

SPIAs and DIAs come in two flavors insofar as the length of time that life insurance companies are on the hook for making payments to you: life annuities and period certain annuities. While SPIAs have traditionally been favored over DIAs, life annuity payment modes have generally been chosen over period certain annuities. This is understandable since most people don’t want to run out of money, with married couples preferring income to last for the remainder of both individuals’ lifetimes.

A life, or joint life, payout, can be a great choice in certain situations, however, if your goal is to create a retirement income plan that provides for different and distinct income streams to match your expense needs associated with different stages of your retirement years, it probably won’t be the best solution. Also, a lifetime payout, due to the open-ended nature of the number of payments, is the most expensive annuitization choice. Finally, unless you purchase an appropriate amount of life insurance in conjunction with the commencement of lifetime annuitization of a fixed annuity, you could potentially lose your entire investment after receiving just one annuity payment.

Let’s take a look at the last situation first since it is potentially the most devastating. Suppose that you are 65 and the value of your fixed income annuity is $250,000 when you decide to annuitize it, choosing a life annuity payment option resulting in a $1,400 per month payment to you for the rest of your life. This seems like a good deal to you since you will be receiving $16,800 a year, or 6.7% of the current value of your investment each year for the rest of your life. After receiving your first electronic deposit (whatever happened to checks?) for $1,400, you die in a car accident. Guess what? Game over. Life insurance company passes go and retains $248,600 ($250,000 – $1,400). Your beneficiaries receive nothing.

The previous example, while it’s certainly possible, is not your typical scenario. What’s more likely to occur is that you will live for a longer period of time, say ten, twenty, or even thirty years, receiving $1,400 each and every month. While it may not end up being such a great deal if you live to 75 since you will receive a total of $168,000, or $82,000 less than the value of your investment of $250,000 when you began receiving payments, if you live twenty or thirty years, you will receive payments totaling $336,000 or $504,000, respectively.

While you may receive payments under a life payout option for an extended period of time that may meet your needs when you retire, this generally won’t be the case after five or ten years due to inflation. Assuming 3% inflation, your $1,400 per month payment will be worth $1,045 in ten years, $775 in twenty years, and $580 in thirty years. Unless your retirement income plan includes another source of income kicking in ten years into your retirement, e.g., a deferred income annuity, or DIA, you may be forced to adjust your lifestyle and/or sell your house in order to cover your expenses.

Finally, when deciding between different payment options, always keep in mind that a lifetime payout is always going to be the most expensive way to go. When you choose this option, and assuming that you are 65 when you begin receiving payments, keep in mind that the life insurance company is potentially liable for making payments for 30, 40, or more years. Due to the open-ended nature of the number of payments combined with increasing life expectancies, the monthly payment that you will receive by choosing a life, or joint life payout, will usually be much less than if you choose a term certain, e.g., twenty years, payout.

Annuities Deferred Income Annuities Retirement Income Planning

Deferred Income Annuities: The Sizzle in a Retirement Income Plan

The blog post two weeks ago, Using Fixed Income Annuities to Build Your Income Portfolio Ladder, introduced a powerful income laddering strategy using a customized blend of two types of fixed income annuities to create and optimize retirement income. The purpose of the strategy bears repeating since it is the catalyst for this week’s blog. As discussed two weeks ago, this strategy offers retirees the benefit of predictable inflation-adjusted income streams to close projected income gaps as well as generate tax efficiency for the nonretirement portion of one’s portfolio while reducing exposure to the gyrations of the stock market.

The two types of fixed income annuities that are used to implement this strategy are immediate and deferred. Immediate income annuities, or “SPIAs” (the acronym for single premium immediate annuities) was the subject of last week’s blog. I encourage you to read this post if you haven’t done so already. It discussed the unique characteristics and benefits of SPIAs that often position them as the cornerstone of retirement income plans. This week’s blog focuses on the second type of fixed income annuity that is used to create and optimize retirement income – deferred income annuities, or “DIAs.”

As noted in Using Fixed Income Annuities to Build Your Income Portfolio Ladder, while the use of SPIAs is widespread, deferred income annuities, or “DIAs,” are currently offered by only a handful of life insurance companies. These include Hartford Life, Prudential, and Symetra Life Insurance Company.

DIAs are similar to SPIAs since they both pay periodic income for a specified period of time or over one’s lifetime or joint lifetimes as applicable. Unlike SPIAs, however, the start date of the payments for DIAs is deferred for at least 13 months from the date of investment. Whereas SPIAs may be viewed as the steak in a retirement income plan, DIAs are the sizzle.

Why use DIAs in a retirement income plan? As illustrated in Immediate Income Annuities: The Cornerstone of a Successful Retirement Income Plan, an individual SPIA can solve many income needs due to its many unique characteristics and benefits. As pointed out in Is Your Income Portfolio Plan Laddered?, our financial situation and needs will change at different stages of our retirement years. As a result, the primary goal of an income plan should be to generate different and distinct income streams to match our expense needs associated with each stage while also funding periodic one-time needs.

Given this reality, the income from a single investment that makes a fixed payment beginning one month after purchase for either a fixed number of years or for the remainder of one’s life, i.e., a SPIA, while it may, in combination with other income sources, match one’s income needs for the first several years of retirement, generally will not, in and of itself, accomplish this result for the entire duration of most individuals’ retirement. Recognizing this fact, the life insurance industry developed a solution that has all of the wonderful benefits that retirees seek from SPIAs with one big difference: a delayed start date.

As an example of the use of DIAs in a retirement income plan, suppose that you are about to retire, your monthly income need is $6,000, with $2,000 covered by Social Security, and the other $4,000 met by withdrawals from an IRA. The problem is that the value of your IRA account is projected to enable you to take your required monthly withdrawals of $4,000 for only ten years before it is depleted. In addition to your IRA, let’s assume that you also have a nonretirement brokerage account with a value of $700,000. Recognizing your predicament, you invest $500,000 from your brokerage account into one or more DIAs that will begin to pay you $4,000 per month plus an annual increase of 3% for twenty years beginning ten years from today.

In addition to solving a retirement income need that isn’t projected to begin until several years into retirement – ten years in the example – DIAs allow you to take advantage of another often-ignored financial planning strategy: time value of money. If you were to purchase the same income annuity as the one in the example, with a monthly payout of $4,000 with an annual increase of 3% and a twenty-year payout that begins one month from today instead of ten years from today, i.e., a SPIA, in addition to not matching your income needs, you may be required to invest an additional $150,000, or $650,000 from your $700,000 brokerage account.

DIAs are the sizzle in a retirement income plan since you can combine them with SPIAs to design a customized retirement income plan that will enable you to enjoy predictable inflation-adjusted monthly income that, in combination with other source of income, e.g., Social Security, dovetails with your projected income needs for the duration of your retirement while minimizing or eliminating the risks associated with investment in the stock market. I would venture to say that most retirees would be very satisfied with this solution.