Tag: exclusion ratio

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Annuities Deferred Income Annuities Fixed Index Annuities

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

The first three posts in this series discussed five differences between fixed index annuities (“FIA’s”) with income riders and deferred income annuities (“DIA’s”) that will influence which retirement income planning strategy is preferable for funding long-term care insurance (“LTCI”) premiums in a given situation. If you haven’t done so already, I would recommend that you read each of these posts.

This week’s post presents a sample case to illustrate the use of a FIA with an income rider vs. a DIA to fund LTCI premiums during retirement.

Assumptions

As with all financial illustrations, assumptions are key. A change in any single assumption will affect the results. The following is a list of assumptions used in the sample case:

  1. 55-year old, single individual
  2. Planned retirement start age of 68
  3. Life expectancy to age 90
  4. Current annual LTCI premium of $4,000 payable for life
  5. Need to plan for infrequent, although potentially double-digit percentage increases in LTCI premium at unknown points in time
  6. Given assumptions #4 and #5, plan for annual pre-tax income withdrawals of approximately $6,000 beginning at retirement age
  7. Solve for single lump sum investment at age 55 that will provide needed income
  8. Investment will come from a nonqualified, i.e., nonretirement, investment account
  9. One investment option is a fixed index annuity (“FIA”) with an income rider with lifetime income withdrawals beginning at age 68.
  10. Second investment option is a deferred income annuity (“DIA”) with no death benefit and lifetime income payout beginning at age 68.
  11. FIA premium bonus of 10%
  12. FIA annual return of 3%
  13. FIA income rider charge of 0.95% of income rider value otherwise known as the guaranteed minimum withdrawal benefit (“GMWB”)
  14. No withdrawals are taken from the FIA other than the income withdrawals.
  15. All investments are purchased from highly-rated life insurance companies known for providing innovative and competitive retirement income planning solutions.

Investment Amount

The first thing that needs to be solved for is the amount of investment that must be made at the individual’s age 55 in order to produce lifetime annual income of approximately $6,000 beginning at age 68. The goal is to minimize the amount of funds needed for the investment while choosing a strategy from a highly-rated insurance company that’s known for providing innovative and competitive retirement income planning solutions.

It turns out that an investment of $50,000 to $65,000 is needed to produce lifetime annual income of approximately $6,000 beginning at age 68. Given the fact that my goal as a retirement income planner is to use the smallest amount of investment for a fixed income annuity to produce a targeted income stream in order to preserve the remainder of a client’s investment portfolio for my client’s other financial goals, the amount of the investment needed is $50,000.

Results

There are three items we will examine to compare the results between investing $50,000 in a FIA with an income rider vs. a DIA to fund LTCI premiums during retirement. They are as follows:

  • Annual gross income
  • Annual taxable income
  • Value/death benefit

Annual Gross Income

Per the Exhibit, the annual payout, or gross income, from the FIA is $5,764, or $236 less than the annual gross income of $6,000 from the DIA. This equates to a total of $5,428 for the 23 years of payouts from age 68 through age 90.

Annual Taxable Income

If the investment was made in a retirement account like a traditional IRA and assuming there have been no nondeductible contributions made to the IRA, 100% of the income would be taxable. This would be the case for both the FIA or DIA.

As stated in assumption #8, the investment will come from a nonqualified, i.e., nonretirement, investment account. Per Part 2 of this series, this makes a difference when it comes to taxation of the withdrawals. Per the Exhibit, 100% of the annual FIA income of $5,764 is fully taxable vs. $3,066 of the DIA income. This is because the DIA, unlike the FIA, is being annuitized and approximately 50% of each income payment is nontaxable as a return of principal. Over the course of 23 years of payouts, this results in $62,054 of additional taxable income for the FIA vs. the DIA.

The amount of income tax liability resulting from the additional taxable income from the FIA will be dependent upon several factors that will vary each year, including (a) types, and amounts, of other income, (b) amount of Social Security income, (c) potential losses, (d) adjusted gross income, (e) itemized deductions, (f) marginal tax bracket, and (g) applicable state income tax law.

Value/Death Benefit

While the present value of the future income stream of a DIA represents an asset, you generally won’t receive an annual statement from the life insurance company showing you the value of your investment. In addition, while some DIA’s will pay a death benefit in the event that the annuitant dies prior to receiving income, per assumption #10, this isn’t the case in this situation. Consequently, the DIA column of the “Value/Death Benefit” section of the Exhibit is $0 for each year of the analysis.

On the other hand, there’s a projected value for the FIA from age 55 through age 79. This value is also the amount that would be paid to the FIA’s beneficiaries in the event of death. There’s a projected increase in value each year during the accumulation stage between age 55 and 67 equal to the net difference between the assumed annual return of 3% and the income rider charge of 0.95% of the income rider value.

Per the Exhibit, the projected value/death benefit increases from $56,278 at age 55 to $68,510 at age 67. Although the assumed premium bonus of 10% is on the high side these days, this is reasonable given the fact that FIA values never decrease as a result of negative performance of underlying indexes, the assumed rate of return of 3% is reasonable in today’s low index cap rate environment, and the assumed income rider charge of 0.95% of the income rider value is on the upper end of what’s prevalent in the industry. The projected value/death benefit decreases each year from age 68 to age 79 until it reaches $0 beginning at age 80 as a result of the annual income withdrawals of $5,764.

Conclusion

As discussed in Parts 1 – 3 of this series, 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 during retirement in a given situation. Two of the differences, income start date flexibility and income increase provision, haven’t been addressed in this post.

In addition to the five differences, the amount of the investment required to produce a targeted lifetime annual income amount to pay LTCI premiums, including potential increases, will differ depending upon the particular FIA or DIA strategy used. In the illustrated case, which isn’t uncommon today, an investment of $50,000 resulted in an almost identical lifetime income payout whether a FIA with an income rider or a DIA is used.

As illustrated, the taxable income associated with a DIA in a nonqualified environment is much less compared to a FIA. As previously discussed, the amount of tax savings resulting from the reduced taxable income will depend upon an analysis of several factors and will vary each year. Ignoring the potential income tax savings resulting from the tax-favored DIA payouts, the FIA with income rider would be the preferred investment choice for many individuals in this case given the presence, duration, and projected amount of, the investment value/death benefit.

The FIA edge is reinforced by the fact that, unlike most traditional DIA’s, the income start date and associated annual lifetime income payout amount for FIA’s is flexible. This would be an important consideration in the event that the year of retirement changes. Furthermore, this is quite possible given the fact that the individual is 13 years away from her projected retirement year.

As emphasized throughout this series, the purchase of LTCI needs to be a lifetime commitment. Planning for the potential purchase of a LTCI policy should be included as part of the retirement income planning process to determine the sources of income that will be used to pay for LTCI throughout retirement. Whether it’s a FIA with an income rider, a DIA, or some other planning strategy that’s used for this purpose will depend on the particular situation.

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Annuities Deferred Income Annuities Fixed Index Annuities

FIAs With Income Riders vs. DIAs: Which is Right for You? – Part 4 of 5

Retirement Income Center - Puzzle

If you haven’t read the first three parts of this series yet, you may want to do so since it will provide you with the background for this post. The first three parts listed and compared 12 features offered by fixed index annuities (“FIAs”) with an income rider with deferred income annuities (“DIAs”). It organized the 12 features into three categories: (a) offered by DIAs, (b) applicable to DIAs, and (c) applicable to DIAs on a limited basis.

DIAs are a unique investment in and of themselves. As such, they offer features that are unavailable in other investments, including FIAs with income riders. This week’s post discusses the retirement income planning benefits that are applicable to DIAs that aren’t present in FIAs with income riders.

Simply stated, a DIA is (a) the income rider portion of a FIA, (b) minus the income start date flexibility, (c) plus potential annual income inflation adjustments, (d) plus potential term vs. lifetime income opportunity.

Income Rider Portion of a FIA

As discussed in Part 2, DIAs, unlike FIAs, don’t have a traditional investment value associated with them. As such, a DIA is a simpler investment to understand than a FIA since it’s all about a future income stream.

Unlike the payments from FIA income riders that represent income withdrawals, DIA payments are annuity payments. This is an important distinction when it comes to income taxation. When held in a qualified plan such as a traditional IRA, 100% of FIA income rider and DIA payments are taxable as ordinary income.

With nonqualified, or nonretirement plans, income withdrawals from nonretirement FIAs are subject to “last-in first-out,” or “LIFO,” taxation. 100% of all withdrawals up to your income amount are taxable as ordinary income with any subsequent withdrawals received tax-free. Since DIA payments are annuity payments, they benefit from more favorable taxation when held in nonqualified plans. Each payment is subject to an “exclusion ratio” that excludes from taxation the portion of the payment that’s deemed to be a return of principal.

Minus the Income Start Date Flexibility

One of the best features of a FIA with an income rider from a retirement income planner’s perspective is the ability to begin income withdrawals at virtually any future date so long as it’s generally at least one year from the date of purchase and you’ve reached a specified age, typically 50. Most DIAs have a specified income start date and, therefore, don’t offer this flexibility. This downside can be negated to a certain extent by purchasing multiple DIA’s with different start dates.

Plus Potential Annual Income Inflation Adjustments

While it may change in the future, FIA income withdrawals, once they begin, are generally fixed amounts that don’t adjust for inflation. Although it isn’t automatic, the income payout from a DIA, on the other hand, can be structured to increase by a specified annual inflation factor, generally ranging between 3% and 6%.

Plus Potential Term vs. Lifetime Income Opportunity

One of the benefits of income annuities in general, including FIAs with income riders, is lifetime income. This also applies to DIA’s, however, you can also structure a DIA for a specified term. The term can be a certain number of years, however, it can be fine-tuned to a specified number of months.

With a known payment beginning at a specified future date for a specified number of months, you know exactly the total amount of income that will be received over the term of the DIA at the time of purchase. This offers three distinct retirement income planning benefits:

  1. Ability to precisely calculate an internal rate of return
  2. Ability to structure income to dovetail with the amount, frequency, and duration of other projected income sources to meet projected expenses
  3. Ongoing income payment to beneficiaries in the event of death prior to the end of the term

So which is right for you – FIAs with income riders or DIAs? Mark your calendar to read next week’s post to find out.

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Retirement Income Planning

Nonretirement vs. Retirement Plan Investments – What is the Right Mix?

Retirement Income Center

Last week’s post made the point that retirement plans, in and of themselves, generally aren’t sufficient for meeting most people’s retirement needs and, therefore, it’s important to include nonretirement investments in most retirement income plans. The question is, what is the right mix of retirement vs. nonretirement investments?

Like the answer to many financial planning questions, the correct response is, “It depends.” Each situation is different. It all revolves around the interaction between a host of many variables, including, but not limited to, current age, projected retirement age, retirement income goals, insurance coverage, current investments, access to and participation in employer retirement plans, availability of other types of retirement plans, other assets owned, liabilities, current disposable income, projected sources of retirement income, income tax carryover losses, and current and projected income tax rates.

Aside from obvious situations where there are inherent limitations in the ability to make nonretirement investments, e.g., minimal disposable income combined with access to an employer-matching 401(k) plan, a detailed analysis should be performed and monitored periodically by a qualified retirement income planner to determine the optimal mixture of retirement vs. nonretirement investments. In addition, the analysis should include the determination of which individual investments are best suited for inclusion in a retirement plan vs. a nonretirement investment portfolio.

As stated last week, nonretirement investments are simply the same types of investments that you find in retirement plans, i.e., stocks, bonds, mutual funds, exchanged traded funds, annuities, CD’s, etc. While this is true, different types of assets behave differently in retirement vs. nonretirement plans. The behavioral differences are attributable to differing income tax rules associated with each type of investment. Furthermore, different income tax rules apply to the accumulation vs. the distribution stage.

It’s critical to understand the accumulation and distribution income tax differences associated with placing a specific investment in your nonretirement portfolio vs. holding it in your retirement plan. An example of this is annuities. Whether held inside or outside a retirement plan, annuities grow tax-deferred. This means that so long as there are no distributions taken from the annuity, there are no current income tax reporting requirements associated with it. When it comes time to taking distributions, it’s a completely different story. Distributions from annuities held in retirement plans are generally taxable as ordinary income vs. those from nonretirement plan annuities are subject to an exclusion ratio whereby a portion of each distribution is generally nontaxable.

The allocation of investments between retirement vs. nonretirement plans as well as the inclusion of a particular investment in a retirement vs. a nonretirement investment portfolio can make or break a retirement income plan. This definitely falls under the category, “Don’t try this at home.”

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Annuities Income Tax Planning Retirement Income Planning Roth IRA Social Security

Increase Your After-Tax Social Security Benefits – Part 1 of 4

Retirement Income Center

The last two posts, Say Goodbye to Up to 30% of Your Social Security Benefits – Parts 1 and 2 discussed taxation of Social Security benefits. As explained in both posts, up to 50% or 85% of Social Security benefits can be taxable depending upon the amount of one’s “combined income” (50% of Social Security benefits plus adjusted gross income increased by tax-exempt income) compared to specified thresholds that are dependent upon one’s tax filing status (i.e., single, head of household, married filing separate, or married filing joint) and one’s tax rates.

Although, as pointed out in last week’s post, taxation of Social Security benefits has been a thorn in Congress’ side ever since it came into being in 1984, it appears that it’s here to stay. Income taxation of Social Security benefits can be reduced or, in some cases, eliminated, in one or more years with proper planning. While much of the planning is ongoing throughout the years that one is collecting benefits, there are several opportunities that should be analyzed and potentially implemented beginning in one’s 40’s, many years before the receipt of one’s first Social Security check. This post focuses on pre-benefit receipt planning and Parts 2, 3, and 4 address planning strategies during the Social Security benefit receipt years.

Before discussing strategies that can be implemented to reduce taxation of Social Security benefits, let me make clear one strategy that generally isn’t effective. Although it hasn’t been given as much attention the last several years in our low-interest rate environment, income tax and investment planning strategies often include an analysis of after-tax return returns from taxable vs. tax-exempt investments. As mentioned in the previous two posts as well as the beginning of this one, “combined income,” which is the starting point for calculating taxable Social Security benefits, is increased by tax-exempt income. As a result, assuming that your goal is to reduce taxable Social Security benefits, other than the fact that the amount of income from a tax-exempt investment is generally less than the income from a similar taxable investment, inclusion of tax-exempt investments as part of your investment portfolio won’t be of much benefit to you.

Perhaps one of the greatest opportunities for reducing taxable Social Security benefits and ongoing associated taxation of same that can be implemented beginning 20 or more years before the receipt of one’s first Social Security check is a Roth IRA conversion or series of conversions over several years. This strategy was featured in the March 15, 2010 post, Want to Reduce Taxable Social Security Benefits? Consider a Roth IRA Conversion as part of Retirement Income Visions™ extensive Roth IRA conversion series.

As discussed in that post, to the extent that a Roth IRA conversion reduces the amount remaining in your traditional IRA, your required minimum distributions (“RMD’s”) that you must take from your traditional IRA’s beginning when you turn 70-1/2 will be reduced. Reduced RMD’s result in less “combined income” which can reduce the amount of taxable Social Security benefits and can also reduce the marginal tax rate that is applied to the taxable portion of your benefits, resulting in less taxes. It’s important to keep in mind that this strategy, in order to be effective, needs to be implemented before receipt of Social Security benefits. To the extent that it is executed while one is receiving benefits, it will generally increase taxable income and taxation of benefits.

Another strategy than can be implemented well before receipt of Social Security is investment in one or more non-qualified (i.e., not within an IRA or other retirement plan) deferred income annuities, or “DIAs”. For an introduction to this powerful retirement income planning investment strategy, please refer to the November 23, 2009 post, Deferred Income Annuities: The Sizzle in a Retirement Income Plan. When structured as a nonqualified annuity, there are two potential ways that DIAs can be used to reduce taxation of Social Security benefits. First, the payout start and end dates from one or more DIAs can be selected to plan for the amount of income that will be paid out to reduce taxation of Social Security benefits. Secondly, a portion, sometimes very sizeable, of DIA payouts from nonqualified investments are tax-favored since they aren’t subject to income taxation by virtue of an “exclusion ratio.” Furthermore, unlike tax-exempt investment income, the portion that is excluded isn’t added back to “combined income” when calculating taxable Social Security benefits.

Permanent life insurance is another strategy that can be implemented many years before receipt of Social Security retirement benefits to reduce taxation of those benefits. To the extent that there is build-up of cash value within whole life, universal life, or variable universal life insurance policies, this cash value, when not subject to modified endowment contract, or “MEC,” taxation rules, can be distributed either through loans and/or withdrawals during one’s retirement years, often with little or no associated income taxation. To the extent that this is achieved, this will favorably affect taxation of Social Security benefits.

When you get into your later 50’s and get closer to the earliest potential start date for receipt of your Social Security benefits, i.e., age 62, a key Social Security tax-reduction strategy that has been discussed extensively in several of the Social Security posts beginning with the October 4, 2010 post, Plan for the Frays in Your Social Security Blanket – Part 2 of 2, is the choice of benefit start date for you and your spouse if married. While a delay in start date can result in increased total benefits received during one’s lifetime, it will also result in delay of taxation of benefits as well as potential increased after-tax benefits once commencement of benefits occurs.