Annuities Celebration Retirement Asset Planning Retirement Income Planning Roth IRA

Retirement Income Visions™ Celebrates 1-Year Anniversary!

It’s hard to believe that a whole year has gone by since Retirement Income Visions™ initial blog post, but it has! This marks Retirement Income Visions™ 52nd post since it debuted on August 16, 2009 as a weekly blog, with new posts published each Monday morning.

As stated in the initial post, Retirement Income Visions™ Makes Its Debut, the blog, and the associated importance of retirement income planning as a separate and distinct niche, was inspired and motivated by my clients’ experience during the October, 2007 – March, 2009 stock market decline.

Also, as stated in the initial post, my goal in writing Retirement Income Visions™ was, and still is, to bring to your attention innovative planning strategies that you can use to create and optimize your retirement income, and, in many cases, reduce your exposure to adverse financial market conditions. If reader feedback, Twitter followers, and media attention, including a May 15th quote by The Wall Street Journal as the result of the timely publishing of the May 10th post, Be on the Lookout for Roth IRA Conversion Opportunities, is any indication, it appears that I’m off to a great start in achieving this goal.

I’ve covered a broad spectrum of information over the course of the last year, however, it’s been anything but random. If you’re a subscriber or regular reader, you’ve probably noticed the themed approach that’s been used to build upon, and provide a body of knowledge about, different retirement income planning topics. This has included the creation of a customized Glossary of Terms to assist in the understanding of the technical subject matter. The Glossary currently includes definitions of 84 terms.

Following the initial post, the next 11 posts addressed the retirement planning paradigm shift from retirement asset to retirement income planning, including associated risks associated with the former type of planning that has been the impetus for this shift.

The last 8 posts of 2009 focused on creating and optimizing retirement income via strategic systematic implementation of single premium immediate (“SPIA’s”) and deferred income (“DIA’s”) annuities. This series culminated in the December 28, 2009 interview of Curtis Cloke, the inventor of the Thrive® Income Distribution System, one of the leading retirement income planning solutions available to financial advisors.

2010 kicked off with the January 4th publishing of What Tools Does Your Financial Advisor Have In His or Her Toolbox? This post cited a 2009 Fidelity study that 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. The implied dilemma is that not all financial advisors have made the transition from using retirement asset to retirement income planning strategies for their clients.

Beginning with the January 11th post, Year of the Conversion, the last 30 posts have focused on a retirement income planning strategy that, although it has been around since 1998, was thrust into the limelight this year with the removal of its entrance barrier. I’m referring to the Roth IRA conversion technique that, up until 2010, was limited to taxpayers with modified adjusted gross income of less than $100,000.

While anyone who has a traditional IRA can convert part or all of his/her accounts to one or more Roth IRA accounts to embrace the two main attractions of a Roth IRA, i.e., nontaxable distributions and no required minimum distributions (“RMD’s”), this strategy isn’t necessarily beneficial for all traditional IRA owners. This is one area where multi-year income tax and retirement income planning analysis is essential for determining (1) who is a good candidate, (2) how much traditional IRA should be converted, and (3) when conversions should be made. In addition, there are various tricks and traps that need to be understood and incorporated in Roth IRA conversion planning in order to increase the probability for success.

I want to thank all of my readers for taking the time to read Retirement Income Visions™. A special thanks to my clients and non-clients, alike, who have given me great feedback regarding various blog posts. Last, but not least, thank you to my amazing wife, Nira, for all of her support with this endeavor. She has spent many a Saturday morning the last year doing other activities while I’ve been sitting at my desk writing this blog.


Consequences of Not Doing Your RMD Before Your RIC

The lesson of last week’s blog post is that if you’re 70-1/2+, IRS deems the first distributions from your traditional IRA to satisfy your required minimum distribution(“RMD”) and therefore you must always take your RMD before doing a Roth IRA conversion. What are the consequences of not taking your RMD before doing your Roth IRA conversion? This post will answer this question and will discuss how to correct this situation.

At first blush, there would appear to be two potentially serious repercussions:

  1. 50% penalty on the amount that should have been withdrawn but was not, and
  2. 6% excise penalty for every year the money remains in your Roth IRA

Answer 6(c) of IRS Regulation 1.408A-4 (Converting amounts to Roth IRAs) enables you to potentially avoid both penalties by treating this situation as two distinct and separate events:

  1. A required minimum distribution, and
  2. Regular contribution to a Roth IRA vs. a Roth IRA conversion

If you do a Roth IRA conversion without first taking your RMD, IRS deems the portion of the conversion amount that is equal to your RMD amount to satisfy the RMD rules for that year and thus avoid a potential 50% penalty. This assumes that the conversion amount is at least equal to the amount of your RMD. The portion of your conversion amount that is less than your RMD would still be subject to the 50% penalty.

Assuming that your conversion amount is equal to or greater than your RMD amount, you’re out of the woods as far as your potential exposure to the 50% penalty. What about the 6% excise penalty? There are different rules for eligibility for a regular contribution to a Roth IRA vs. a Roth IRA conversion. Since your RMD amount is now treated as a regular contribution to a Roth IRA, your avoidance of the 6% excise penalty depends upon whether or not you are eligible to make a regular contribution to a Roth IRA as well as your RMD amount.

Eligibility for regular contributions to Roth IRA’s is dependent upon having earned income equal to at least the amount of the contribution and is also dependent upon the amount of one’s modified adjusted gross income (“MAGI”) which differs by filing status, the details of which are beyond the scope of this blog post. Even if you meet the eligibility requirements, the maximum amount of your Roth IRA contribution is limited to $6,000 if you’re age 50 or older.

If you don’t meet the eligibility rules for making a regular contribution to a Roth IRA, the portion of your Roth IRA conversion that is deemed to be an RMD will be subject to the 6% excise penalty. Furthermore, even if you satisfy the Roth IRA regular contribution rules, to the extent that the RMD portion of your Roth IRA conversion exceeds $6,000, it will be subject to the 6% excise penalty until it is corrected.

If you are either ineligible to make a regular contribution to a Roth IRA or, if you are eligible and the RMD portion of your Roth IRA conversion exceeds $6,000, how do you correct this situation and avoid the 6% excise penalty? In order to avoid the penalty, you must transfer the portion of the conversion that is deemed to be an RMD that doesn’t meet the Roth IRA regular contribution eligibility requirements plus earnings thereon back to your traditional IRA by the due date, including extension, for filing your tax return for the year of conversion.


Do Your RMD Before Your RIC

I’m not a big fan of acronyms because there’s way too many of them and it’s easy to get confused by them, however, my original title for this post, “Don’t Forget to Take Your Required Minimum Distribution (“RMD”) Before You Do Your Roth IRA Conversion (“RIC”)” was way too long. So, for my fellow non-acronym fans (otherwise known as “NAF’s”), please bear with me on this one.

With the one-year suspension of required minimum distributions (“RMD’s”) in 2009, it’s easy to forget that if you’re at least 70-1/2 years old, you must start, or resume, taking mandatory minimum withdrawals from your traditional IRA accounts in 2010 based on their account value on December 31, 2009 and an IRS life expectancy factor. The RMD rules are even further off the radar screen for those individuals age 70-1/2+ with modified adjusted gross incomes in excess of $100,000 who were previously ineligible for a Roth IRA conversion who were anxiously waiting for 2010 to roll around so that they could finally do a conversion.

If you’re 70-1/2, before you rush out and convert a portion, or all, of your traditional IRA to a Roth IRA, you must first take your RMD. Why is this? If you own a traditional IRA at any time during the year and you’re at least 70-1/2 years old, IRS says that the first distribution from your IRA always includes your RMD amount. Furthermore, RMD’s aren’t eligible to be rolled over to other IRA’s, including conversion to a Roth IRA.

Consequently, even though your RMD and your Roth IRA conversion are both taxed exactly the same way as ordinary income, you must always first take your RMD before converting any portion of your traditional IRA to a Roth IRA. What are the consequences of not taking your RMD before doing a Roth IRA conversion and is there a way to correct this? For the answer to these questions, you’ll need to wait for next week’s blog post.

IRA Roth IRA Social Security

Want to Reduce Taxable Social Security Benefits? Consider a Roth IRA Conversion

Last week’s post, Reduce or Eliminate Your Required Minimum Distributions With a Roth IRA Conversion was a precursor to this week’s topic. It explained how a Roth IRA conversion can be used to reduce, or potentially eliminate, required minimum distributions (“RMD’s”). It also illustrated the growth potential of a distribution-free IRA vs. one that is subject to RMD’s.

In addition to achieving greater growth through a reduced distribution or distribution-free IRA, a Roth IRA conversion can also reduce your taxable Social Security benefits. To the extent that a Roth IRA conversion reduces the amount remaining in your traditional IRA, your RMD’s will be reduced since they are based on the value of your traditional IRA as of December 31st of the preceding year. When you reduce RMD’s, you reduce income that is used in the calculation of taxable Social Security benefits, assuming that you don’t replace your previous RMD income with other taxable income.

The amount of one’s income and filing status determine the amount of taxable Social Security benefits. For this purpose, income includes tax-exempt interest income and 50% of Social Security benefits in addition to all other items of income normally included in the calculation of adjusted gross income. If the resulting total exceeds specified base amounts ($25,000 for single and head of household and $32,000 for married filing jointly), then at least 50%, and up to 85%, of Social Security benefits are taxable.

The easiest way to illustrate the impact of RMD’s vs. no RMD’s on the taxation of Social Security benefits is with an example. Per the attached Taxable Social Security Benefits Example, all facts are identical with the difference being that Case A includes taxable IRA’s, or RMD’s, in the amount of $18,000 vs. $0 in Case B. Case A provisional income of $50,000 exceeds the base amount of $32,000, resulting in taxation of Social Security benefits. $11,100, or 55.5% of Social Security benefits, are taxable. Case B provisional income of $32,000 is identical to the base amount, resulting in no taxation of Social Security benefits.

While the amount of your income excluding RMD’s may be in excess of the Social Security base amount, resulting in taxation of your Social Security benefits, you may be able to reduce the percentage of your taxable Social Security benefits below 85%, and possibly as low as 50%, by reducing your RMD’s via one or more Roth IRA conversions. This can result in significant income tax savings for many years.

When deciding whether or not to do a Roth IRA conversion, as well as the amount of same, whether you’re 40 years old or 70 years old, always keep in mind the impact of your decision on the potential taxation of your current and/or future Social Security benefits.


Reduce or Eliminate Your Required Minimum Distributions With a Roth IRA Conversion

A lot of people I talk to get upset when they discover that they must begin taking required minimum distributions (“RMD’s”) from their traditional IRA’s beginning at age 70-1/2. They forget about all of the income tax savings that they’ve realized over the years from either making deductible IRA contributions or from making pre-tax contributions into 401(k) plans that they rolled over into their IRA accounts. This is especially true when they haven’t reinvested the tax savings from their deductible contributions which is fairly typical.

Moreover, many people don’t realize that IRS has authorized a deduction for their contributions in exchange for the right to tax distributions from their traditional IRA’s, whether voluntarily or via RMD’s. Whether or not you’ve taken any distributions from your IRA, beginning at age 70-1/2, you are required to take a minimum distribution each year from your traditional IRA accounts based on their value on December 31st of the preceding year and an IRS table life expectancy factor. The taxable portion of each distribution includes deductible contributions as well as earnings.

One way to “beat the system” and reduce, or potentially eliminate, your RMD’s is to do one or more Roth IRA conversions. Depending upon the amount of your Roth IRA conversion and your overall tax situation in a particular year, you may or may not incur tax liability in connection with your Roth IRA conversion. See The Ideal Roth IRA Conversion Candidate – Parts 1 and 2 and Two Great Roth IRA Conversion Candidates for strategies for reducing or potentially eliminating income tax liability in connection with a Roth IRA conversion. Whether or not you incur income tax liability, you will reduce your RMD amounts and eliminate them if you convert 100% of your IRA to a Roth IRA.

It’s important to keep in mind that by reducing or eliminating future RMD’s, you are doing so not only based on the current value of your IRA, you are also eliminating RMD’s attributable to future earnings. Furthermore, if you have children who will eventually inherit your IRA’s, you are reducing or eliminating their RMD’s as well.

To illustrate the potential power of elimination of RMD’s, I have prepared two spreadsheets as follows:

  1. Projected IRA Balances with Required Minimum Distributions (IRA #1)
  2. Projected IRA Balances Without Required Minimum Distributions (IRA #2)

The spreadsheets were prepared using the following assumptions:

  • Traditional IRA balance of $100,000 at age 50
  • Maximum annual contributions to traditional IRA’s from age 50 through age 69 on January 1st of each year
  • Maximum allowable contributions of $6,000 increased by $500 per year every five years
  • Earnings at 5%
  • Withdrawals of required minimum distributions only on January 1st of each year beginning at age 70 through age 85 in IRA #1

Per IRA #1, after withdrawing RMD’s totaling approximately $404,000 over 16 years, the IRA is projected to be worth approximately $478,000 at age 85. Per IRA #2, with no RMD’s, the value of the same account is projected to grow to approximately $1.079 million at age 85. Depending upon the amount of income tax liability attributable to IRA #1’s RMD’s and what the IRA owner does with the after-tax distributions, i.e., spends or reinvests, would allow a more thorough comparison of IRA #1 to IRA #2. In addition, it must be kept in mind that in order to eliminate RMD’s, the owner of IRA #2 would need to do a Roth IRA conversion at age 69, and, in the process, increase taxable income in that year by approximately $494,000.

A Roth IRA conversion can provide you with an opportunity to reduce or eliminate your RMD obligation as well as that of your children if they will inherit your IRA’s. Before doing any conversion, however, a detailed analysis should be prepared to determine if the projected benefits to be derived from a conversion, including the reduction or elimination of RMD’s, is worth the cost, i.e., the tax liability attributable to the conversion.


Two Great Roth IRA Conversion Candidates

In the two previous blog posts, I examined four scenarios where it’s possible to convert a portion, and possibly all, of a traditional IRA to a Roth IRA while incurring minimal or no income tax liability attributable to the conversion, and, as such, qualify as ideal Roth IRA conversion candidates.

This week’s blog presents two additional Roth IRA conversion candidates that I would classify as “great,” but not “ideal,” candidates. Both scenarios have the potential for the IRA owner or beneficiaries to end up with more assets than they would if they don’t do a conversion, however, there could be a sizeable amount of income tax liability attributable to the conversion, depending upon the situation. The two scenarios are as follows:

  1. Substantial basis in IRA
  2. Surviving spouse in low tax bracket not dependent on IRA with children in high tax bracket

Substantial Basis in IRA

Whether or not you’re considering a Roth IRA conversion, if you’re an IRA owner, it’s important to know the amount of your basis in your IRA. What does this mean? If the origin of your IRA is entirely from deductible IRA contributions or other deductible retirement plan contributions assuming your IRA was rolled over from a qualified retirement plan, such as a 401(k) plan, then your basis is $0. When you either take distributions from your IRA or do a Roth IRA conversion, 100% of your distributions or conversion amount will be taxable.

On the other hand, suppose that part or all of your IRA came from either nondeductible IRA contributions or after-tax contributions from a qualified retirement plan that was rolled over to your IRA. In this case, distributions from your IRA or Roth IRA conversions that are attributable to your nondeductible IRA contributions or qualified retirement plan after-tax contributions will be nontaxable. All prior year, as well as current year, nondeductible and after-tax contributions are required to be reported to IRS on Form 8606 – Nondeductible IRAs.

As an example, I had a client recently approach me about converting his wife and his IRA accounts to Roth IRA accounts. The combined value of their IRA accounts is $98,000 with a basis arising from nondeductible IRA contributions totaling $67,000. Assuming they convert 100% of their respective IRA accounts to Roth IRA accounts, they would recognize ordinary income equal to the difference between the account values of $98,000 and their basis of $67,000, or $31,000. This is less than one-third of the total value of their IRA accounts.

Even though my clients are in a combined 45% federal and state marginal income tax bracket, resulting in income tax liability of approximately $14,000 attributable to a Roth IRA conversion, this is only 14% of the total combined value of their IRA accounts of $98,000. Taking into consideration the fact that my clients are in their early 40’s, they may never need to take distributions from their IRA accounts, they have nonretirement funds from which to pay the tax attributable to the conversion, and the stock market is currently priced well below its highs of a couple of years ago, I encouraged them to pursue a conversion of 100% of their respective traditional IRA accounts to Roth IRA accounts.

Surviving Spouse in Low Tax Bracket Not Dependent on IRA With Children in High Tax Bracket

The second great candidate for conversion of a portion, or all, of a traditional IRA to a Roth IRA is a surviving spouse who meets the following three criteria:

  1. Low tax bracket
  2. Not dependent on IRA
  3. Has one or more children who are in a high tax bracket

The goal here is to reduce, or potentially eliminate, income tax liability that the surviving spouse’s beneficiaries will incur upon inheriting a traditional IRA since they will be required to take minimum distributions each year from their inherited IRA’s. Anyone in this situation should have a multi-year income tax projection prepared to determine the amount of traditional IRA that should be converted to a Roth IRA in the current and future years while keeping the surviving spouse in a relatively low tax bracket.

While both of these scenarios are not ideal Roth IRA conversion candidates since they could result in a sizeable amount of income tax liability upon conversion, they nonetheless present great opportunities to end up with greater assets than without doing a Roth IRA conversion, especially when beneficiaries are considered.


Three Roth IRA Conversion “Show Stoppers”

Effective January 1st this year, the $100,000 modified adjusted gross income barrier for converting traditional IRA accounts to Roth IRA accounts was eliminated. Now that the floodgates are open and everyone can convert their traditional IRA’s to Roth IRA’s, if you haven’t done so already, should you jump on the bandwagon? While the potential benefits of tax-free withdrawals and not being subject to required minimum distributions (“RMD’s”) (See Year of the Conversion) are extremely attractive, there are several obstacles one must overcome before switching horses.

Before discussing these obstacles, which will be continued in next week’s blog post, it’s important to keep in mind that when contemplating a Roth IRA conversion, it doesn’t have to be an all-or-nothing event. You can, and it’s often preferable, to do partial conversions of traditional to Roth IRA’s over one or more years.

There are three scenarios, in my opinion, that are “show stoppers” when evaluating a potential Roth IRA conversion:

  1. Primary beneficiary of traditional IRA is a charity
  2. 100% of retirement plan funds are invested in an active 401(k) plan
  3. No source of funds for payment of Roth IRA conversion tax liability outside of retirement plans

Primary Beneficiary of Traditional IRA is a Charity

The first thing one should do when considering a Roth IRA conversion is to examine the beneficiary designation of the IRA account(s) to be converted. If the beneficiary is a charitable organization, it generally doesn’t make sense to prepay income taxes if there is a possibility that there will be a tax-free distribution of the IRA to a charity.

100% of Retirement Plan Funds Are Invested In An Active 401(k) Plan

Sometimes people will roll over inactive pension plans, including 401(k) plans, into a traditional IRA and then convert the traditional IRA to a Roth IRA. If you are an active participant in a 401(k) plan, short of borrowing or taking a hardship withdrawal from the plan if permitted by the plan, you are prohibited from taking distributions from the plan prior to attaining age 59-1/2 or separation from service.

No Source of Funds for Payment of Roth IRA Conversion Tax Liability Outside of Retirement Plans

Assuming that you aren’t one of the fortunate individuals who is able to do a tax-free Roth IRA conversion, after calculating the potential income tax liability attributable to your conversion, you need to ask yourself the following question: What will be the source of payment of the income tax liability attributable to your Roth IRA conversion?If you don’t have sufficient funds in checking, savings, money market, and other nonretirement investment accounts outside of your IRA to pay the tax attributable to a Roth IRA conversion, you aren’t a good candidate for a Roth IRA conversion.

When you incur income tax liability in connection with a Roth IRA conversion, you always want to pay the income tax from funds outside of retirement plans, including the traditional IRA being converted. If you elect to have income tax withheld from your traditional IRA being converted to a Roth IRA, in addition to reducing the amount of the conversion by the amount of income tax withheld, if you are under age 59-1/2, you will be subject to a 10% premature distribution penalty on the amount of withholding since it is considered to be a distribution from your IRA that is not converted to a Roth IRA within 60 days.

Paying the tax from other retirement plans is also self-defeating since the funds will no longer continue to grow tax-deferred, there will be a taxable distribution, and, to the extent that you are under age 59-1/2, you will be subject to a 10% premature distribution penalty on the amount of the distribution.

If the primary beneficiary of your traditional IRA account isn’t a charitable organization, 100% of your retirement plan funds aren’t invested in active 401(k) plans, and you have funds outside of retirement plans to pay the income tax liability attributable to your Roth IRA conversion, put on your running shoes and get ready to run the high hurdles in Clearing the Roth IRA Conversion Hurdles, the topic of next week’s blog post.


Year of the Conversion

If you grew up in my generation, you probably remember Al Stewart’s 1976 hit, “Year of the Cat” from his platinum album with the same name. Well, 34 years later (boy, am I getting old!), 2010 is being dubbed by the financial community as the “Year of the Conversion” in reference to the removal of the income threshold in connection with Roth IRA conversions.

Although the Roth IRA and the Roth IRA conversion technique were both established by the Taxpayer Relief Act of 1997 for taxable years beginning in 1998, like a lot of tax legislation that provides for potentially favorable benefits, the ability to  take advantage of the latter until now has been dependent on one’s income level. From 1998 through 2009, only taxpayers with modified adjusted gross income of less than $100,000 were eligible to convert a traditional IRA to a Roth IRA.

It wasn’t until January 1st of this year that the $100,000 income threshold was eliminated as a result of the Tax Increase Prevention and Reconciliation Act (TIPRA) of 2005. Now anyone who has a traditional IRA can convert part or all of his/her accounts to one or more Roth IRA accounts.

What’s So Special About a Roth IRA?

Like a traditional IRA, Roth IRA’s enjoy tax-exempt growth. So long as you don’t take any withdrawals from either a regular or Roth IRA, you won’t pay income taxes on the income earned. This includes interest, dividends, and realized gains from securities sales. Unlike a traditional IRA to which you may make potentially deductible contributions depending on your income, contributions to a Roth IRA aren’t deductible.

So if contributions aren’t deductible and you receive the same tax-exempt growth as a traditional IRA, why do a Roth IRA? There are two main attractions of a Roth IRA that aren’t available to traditional IRA owners:

  1. Nontaxable distributions
  2. No required minimum distributions (“RMD’s”)

Nontaxable Distributions

Whenever a deduction is allowed for contributions to a retirement plan, whether it be an IRA, 401(k), or some other type of pension plan, withdrawals from the plan are taxable as ordinary income just like salary. Since contributions to a Roth IRA aren’t deductible, withdrawals generally aren’t taxable.

There is, however, an important exception to this rule. Any distributions, with limited exceptions that are beyond the scope of this blog post, that aren’t attributable to non-deductible IRA contributions will be taxable as ordinary income if they are taken before the later of (a) five years after the Roth IRA owner established and funded his or her first Roth IRA account or, in the case of a Roth IRA conversion, five years from the date of the conversion, or (b) age 59-1/2. In addition, if the distribution is from a Roth IRA conversion and you are less than 59-1/2 when you take your distribution, it is also subject to a 10% premature distribution penalty.

No Required Minimum Distributions (“RMD’s”)

Whereas contributions to traditional IRA’s are potentially deductible and the accounts also enjoy tax-exempt growth until you begin taxing withdrawals from them, IRS doesn’t allow this nirvana to continue indefinitely. Once you turn 70-1/2, you must begin taking annual required minimum distributions, or “RMD’s,” from your traditional IRA based on the value of your IRA accounts at the end of the previous year using a life expectancy factor from an IRS table. A 50% penalty is assessed on the amount of any RMD’s not distributed.

Roth IRA’s are not subject to the RMD rules during the owner’s lifetime. You can convert 100% of a traditional IRA to a Roth IRA at age 25 and not take any distributions from it for the duration of your life without being exposed to any penalties. Once again, IRS doesn’t allow this benefit to continue indefinitely. Roth IRA’s are subject to RMD’s after the death of the owner. Therefore, if you inherit a Roth IRA, you will be required to take minimum distributions from it.

As you can see, even though we’re in the midst of the “Year of the Conversion,” the two main attractions of a Roth IRA are not bullet-proof. With this in mind, should you convert your traditional IRA to a Roth IRA? Hmm, sounds like an idea for another blog post!

Annuities Retirement Income Planning

Immediate Income Annuities: The Cornerstone of a Successful Retirement Income Plan

Last week’s blog post introduced a powerful income laddering strategy using a customized blend of fixed income annuities to create and optimize retirement income. As discussed, 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. Two types of fixed income annuities were introduced: immediate and deferred, with the former being the subject of this week’s blog.

Annuities have a long history, tracing their roots to Roman times. Contracts during the Emperor’s time were known as annua, or “annual stipends” in Latin. Roman citizens made a one-time payment in exchange for a stream of payments for a fixed term or for life.

In 1653, a Neapolitan banker named Lorenzo Tonti developed a system for raising money in France called the tontine whereby individuals purchased shares in exchange for income generated from their investment. As shareholders died, their income was spread among the surviving investors until the last person alive collected all of the remaining benefits. Although the use of tontines spread to Britain and the United States to finance public works projects, it was eventually banned since it created an incentive for investors to eliminate their fellow investors in order to obtain a larger payout.

Private sector annuities have been available in the United States for over two centuries. In 1759, Pennsylvania charted a company to provide survivorship annuities for families of ministers. In 1912, The Pennsylvania Company for Insurance on Lives and Granting Annuities was founded and became the first American company to offer annuities to the general public.

The earliest commercial annuities became the predecessor for immediate income annuities, otherwise known as single premium income annuities, or “SPIAs,” that are in widespread use today.

Immediate income annuities, or SPIAs, are distinguished from deferred income annuities, or DIAs, based on the timing of commencement of payments from the insurance company to the annuitant. “Immediate” is somewhat of a misnomer since the payments don’t begin immediately after investment in an annuity contract. Most annuity investors choose a monthly payout and therefore receive their first payment from a SPIA one month after purchase. Initial payments will be delayed for one quarter, six months, or a year when quarterly, semi-annual, and annual payout modes, respectively, are elected.

While a customized blend of SPIAs when used in conjunction with deferred income annuities, or DIAs, can be an ideal retirement income laddering strategy, an individual SPIA can solve many income needs. As such, it’s often used as the cornerstone of retirement income plans. SPIAs’ unique characteristics and benefits are very appealing to retirees since they include the following, several of which also apply to DIAs:

  1. Immediate, predictable, guaranteed income (subject to individual insurers’ claims-paying ability), often for life, beginning at retirement
  2. Protection against outliving assets
  3. Flexible choices of payment plans to meet one’s needs
  4. Choice of frequency of payments
  5. Reduction of income tax liability through tax-favored status in nonretirement accounts, potential reduction of taxable Social Security benefits, and reduction of required minimum distributions (RMDs) in retirement accounts
  6. Reduced exposure to fluctuation of the stock market to the extent that funds used to purchase SPIAs were previously invested in the market
  7. Reduced dependence on ongoing investment management and associated reduction of investment management fees to the extent that funds used to purchase SPIAs were previously professionally managed

As a tradeoff for the foregoing seven benefits, it must be kept in mind that the purchase of all annuity contracts, including SPIAs, is usually an irrevocable action. Once an annuity has been purchased, the owner doesn’t have the right to terminate the contract and request a refund without incurring a substantial penalty. In addition, depending upon how the payout is structured, it could last for many years, potentially over the lifetimes of two or more individuals.

Immediate income annuities, when properly customized for a particular financial situation, can result in reduced financial worries and an associated positive retirement experience. While they can be an effective cornerstone for many retirement income plans, however, they usually aren’t a total solution for creating and optimizing retirement income.