Tag: last-in first-out

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Annuities Deferred Income Annuities Fixed Index Annuities Longevity Insurance

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

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 Income can typically be withdrawn beginning one year from the initial issue date with no time limit after that.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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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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Annuities Fixed Index Annuities

Fixed Index Annuity Income Rider Similarities to Social Security – Part 4 of 4

Retirement Income Center - Currency

This is the fourth and final part of our series discussing eight characteristics that are shared by fixed income annuity (“FIA”) income riders and Social Security. The first seven characteristics of a fixed index annuity income rider were addressed in Parts 1 through 3, with #8, income taxation, the topic of this week’s post.

There are three income taxation attributes that FIA income riders and Social Security have in common as follows:

  1. Limited income tax deduction for investment funding
  2. Tax-deferred growth
  3. Benefits taxable as ordinary income

Limited Income Tax Deduction for Investment Funding

With qualified pension plans, e.g., 401(k) plans, there are pre-tax deductions available for employer and employee contributions up to specified limits. In the case of Social Security and FIA income riders, tax savings from initial and ongoing investment funding is limited.

For Social Security, the ability to take an income tax deduction is limited to employer contributions. Employee contributions are nondeductible. For 2012, employers may deduct their contributions of 6.2% of Social Security earnings up to a maximum of $110,100 per employee. Self-employed individuals may deduct the employer portion of Social Security and Medicare tax, with the limit being identical to the employer portion of employee Social Security earnings.

When it comes to FIA funding, income tax deductibility is determined by FIA location. Like most investments, FIA’s can be held in nonretirement and retirement investment accounts. Contributions to nonretirement investment accounts are non-deductible. Contributions to retirement investment accounts, on the other hand, may or may not be deductible, depending upon the type of investment account and other rules, a discussion of which is beyond the scope of this post.

Tax-Deferred Growth

An important advantage enjoyed by both Social Security and FIA income riders is tax-deferred growth. Simply stated, there’s no taxation until payments are received. With Social Security, tax-deferred growth happens behind the scenes. Unlike 401(k) plans and IRA’s where each participant has a separate account where tax-deferred growth can be tracked, this isn’t the case for Social Security recipients. Tax-deferred growth is instead transparent since there’s no direct correlation between employee and employer Social Security contributions and benefits that are ultimately paid.

Although tax-deferred growth doesn’t occur behind the scenes, it isn’t as straightforward as with other investments, including the FIA accumulation value, when it comes to a FIA income rider. Income withdrawals are calculated based on a separate income account value. Please see the April 2, 2012 post, How is Your Fixed Index Annuity’s Income Account Value Calculated? to learn more.

Benefits Taxable as Ordinary Income

When taxable, Social Security and FIA income rider benefits are both treated as ordinary income. This means that, unlike long-term capital gains which enjoy a favorable tax rate, benefits are taxed at one’s regular income tax rates. The rates range between 10% and 35% and are dependent upon filing status and amount of taxable income.

The taxation of Social Security is dependent upon the total of one’s other income, tax-exempt interest, and one-half of Social Security benefits compared to a specified threshold amount that’s different for single and married taxpayers. When the total exceeds the threshold amount and benefits are taxable, anywhere between 50% and 85% of benefits are taxable as ordinary income depending upon the amount of the excess of the total over the threshold amount.

The taxation of FIA income rider withdrawals is dependent upon FIA location. When held in qualified plans and non-Roth IRA’s, 100% of all withdrawals in excess of one’s basis are taxable as ordinary income. Withdrawals from Roth IRA accounts are nontaxable. If not annuitized, income withdrawals from nonretirement FIA’s are subject to “last-in first-out,” or “LIFO,” taxation. 100% of all withdrawals will be taxed until all interest is recovered with subsequent withdrawals received tax-free as a return of principal.

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Annuities Fixed Index Annuities Income Tax Planning

Annuitization Tax Treatment of Nonretirement Distributions

Retirement Income Center

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.

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Annuities Fixed Index Annuities

Your Fixed Index Annuity Income Rider – What You Don’t Receive – Part 2 of 2

Retirement Income Center

Per Part 1 of this two-part series, before we talk about what you receive when you purchase an income rider with a fixed index annuity, it’s important to understand what you don’t receive. As stated last week, this needs to be placed in the context of fixed income annuities. If you haven’t done so already, I recommend that you read last week’s post before continuing with this one.

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:

  1. Annuitization
  2. Immediate payments
  3. Ability to receive payments over a fixed period
  4. Annuitization tax treatment of nonretirement distributions

The first three things will be addressed in the remainder of this post, with a discussion of annuitization tax treatment of nonretirement distributions deferred to next week.

Annuitization

As explained last week, one of the unique features that’s associated with a fixed income annuity is the right to annuitize, or receive an income stream for a specified length of time from your investment. While you retain the right to annuitize the accumulation value of a fixed index annuity, the determination of income rider payment amounts is a separate calculation, independent of the accumulation value. Although they reduce the accumulation value of the contract, income rider payments are deemed to be withdrawals vs. annuitization of the contract. This is an important distinction when it comes to income tax treatment as you will learn about next week.

Immediate Payments

With a fixed index annuity income rider, you have flexibility as to when you begin receiving your income so long as you don’t need the income right away. Unlike fixed income annuities, however, where the payments that you receive can be either immediate or deferred, with fixed index annuities, the earliest income starting date generally doesn’t begin until twelve months after the contract’s issue date.

Ability to Receive Payments Over a Fixed Period

Another important difference between a fixed income annuity and the receipt of income payments using an income rider that’s attached to a fixed index annuity is the payment duration. Per Part 1, when you annuitize a fixed income annuity, the payments are made (a) over a stated period of months or years, or (b) for the duration of the insured’s and potentially his/her spouse’s and/or other individuals’ lifetime(s) depending upon the payout option selected. With a fixed index annuity, payments are for life. This is the case even if there’s no accumulation value remaining in the fixed index annuity.