Annuity Nuts and Bolts

You have been saving for retirement for many years and have amassed a nice nest egg of savings. Now is the time to determine the products and services that best fit your retirement needs. First of all, you need to realize that the most important part of your retirement planning is your investing.

You may have one set of products that you use during the “accumulation phase” of planning the saving and investing during your working years; and another during your actual retirement years, where the emphasis will be on wisely utilizing your nest egg.

People use stocks and mutual funds during the”accumulation phase.”  A stock is a share in the ownership of a company. For the company, a stock is a fundraising loan that they needn’t repay, but will typically yield greater income for both the company and its shareholders in the end. As an owner, you are entitled to your share of the company’s wealth.

A mutual fund is a lower-risk investment. Investors pool their money and allow professionals to select stocks for them. While stocks may generate a larger return, mutual funds are better for retirement planning because of their low risk and maintenance. 

A word of caution though, Mutual Funds can also possess much more risk than you thought you were encountering. So beware, stocks and mutual funds can be daunting since there’s always the risk that the company won’t be profitable and you’ll lose your investment. 

In the stock market, many investors will simply look at how a stock price of the company’s doing, and jump aboard only because the price is going up. There may be no profits at all behind that particular company (in fact there often aren’t) but they will still invest anyway, because their stock broker called them up and told them to.

Putting your retirement at risk doesn’t make sense to most retiree’s. What is your aversion to risk? Do you want to embrace investment risk, or do you seek to encounter as little risk as possible.  The high risk outweighs the high return to me.

But how does that nest egg translate to an income stream, and how much income can you take from your savings?

There have been dozens and dozens of studies and methodologies discussing sustainable withdrawal rates from retirement portfolios. Conventional industry wisdom considers a 4 percent withdrawal rate to be a “rule of thumb”.

However, where do you withdraw the 4 percent from? Should you take it from your 401(k), your Roth IRA, or your investment portfolio? Generally, you want to start taking withdrawals from your taxable accounts first, such as your investment portfolio.

Then start withdrawing from your tax-deferred accounts, such as your 401(k), and finally from your tax-free account, such as Roth IRAs. The thought process is that you want to allow your tax-advantaged accounts, like Roth IRAs and 401(k) s, to grow for as long possible. However, you must start taking required minimum distributions from your tax-deferred accounts when you turn 70½.

Some people prefer peace of mind and do not want to be disturbed by everyday fluctuation of the market or bothered by continuous management of one’s portfolio. For investors looking to diversify their retirement portfolio and provide a steady stream of income, annuities may offer a great choice. An annuity is one of the most popular options for investors who are approaching retirement by using an annuity to round out your retirement nest egg.

Converting to Annuity

Easy to understand and administer, this option of managing one’s retirement savings can provide a stable and guaranteed income for a specified period of time or for life. There is a fixed rate of interest associated with this. There are many annuity choices and plans available from which a retiree can make a selection.

Benefits 

For retirees looking for a steady income from a lump sum of money, an immediate annuity has several advantages over other alternatives. The monthly payment amount will usually be higher than other investments and guaranteed by the issuing insurance company. A large portion of the annuity payment will be exempt from income taxes, boosting the after-tax income compared with other investments.

Function 

An immediate annuity is usually purchased to provide a lifetime income to the annuitant. The annuity will pay a regular monthly or annual check until the annuitant dies, whether it is in a few months or after 40 years. Immediate annuities have options that will guarantee a minimum payout or payment for a minimum number of years if the annuitant dies early. Annuities will usually provide a higher level of income than CDs or bonds because the principal amount is paid to the insurance company and will not be returned. The annuity provides an income that cannot be outlived.

Significance  

The Internal Revenue Service considers immediate annuity payments a partial return of principal plus interest. The principal value is divided over the life expectancy of the annuitant at the time the annuity payments are started. For example, if the IRS life expectancy tables showed the annuitant had a 20-year life expectancy, the amount paid for the immediate annuity would be divided by 20 and that amount would be excluded from taxable income on the annuity payment. If the annuitant lives longer than the computed life expectancy, the annuity payments will become fully taxable.

Identification

The insurance company that quotes an immediate annuity will show the monthly or annual payment for the amount of annuity purchased and an exclusion percentage or amount. The exclusion percentage is the portion of each annuity payment excluded from income taxes. Subtracting the exclusion amount from the annual payment will provide the amount of taxable income from the immediate annuity.

An annuity makes regular payments to an insured individual in exchange for either regular contributions over time (a deferred annuity) or one lump sum of money (a deferred or immediate annuity). Annuity income is taxable.

Tax on Withdrawals

You are taxed at ordinary income tax rates when making withdrawals from your deferred annuity. Additionally, withdrawals are considered to be a withdrawal of interest earnings and are fully taxable. Principle is withdrawn after interest earnings have been depleted.

Exclusion Ratio

Immediate annuities are subject to an exclusion ratio. An exclusion ratio means that part of the annuity payment is considered to be principal, while part of the annuity payment is interest earnings. The principal payment is not subject to taxation but the interest earnings are. The excluded amount depends entirely on your age and the interest rate the insurance company is paying on the annuity.

Considerations

You will be taxed on 100 percent of your withdrawals in a deferred annuity, but you will have access to all of your savings in the annuity account. With an immediate annuity, you do not have access to your savings. Instead, you receive the exclusion ratio and steady payments from the insurance company.

Tax-qualified money is from retirement plans and IRAs. If qualified money is used to purchase an immediate annuity, the tax rules for those types of plans will apply. A non-qualified immediate annuity is purchased with money from other sources such as savings or investments. The immediate annuity purchased with non-qualified money pays a tax-advantaged regular income.

Reasons for using an immediate annuity

There are some upsides to any product. Ultimately, the question is whether these could sufficiently outweigh the downsides in your situation.

a) Security and stability

That annuity income is secure, stable and must provide an income until the day that you die is a major advantage. The immediate annuity is regarded as low-risk to no-risk.

b) Tax treatment

The income that you receive as an immediate annuity payout is either not subject to tax or enjoys favorable tax treatment. However, this is not a major benefit if you consider that the funds used to invest in the annuity are taxed already.

c) Creditor protection

The annuity also provides a safe haven from the lien of creditors. Annuity payouts are not normally under consideration when you file for bankruptcy or have debt obligations.

d) Qualification for State benefits

That you exchange a lump sum for reduced payments means that you’re giving up capital for income. The nature of this exchange means that for state benefits (such as Medicaid) that have a financial threshold for qualification, the lump sum allocated to an immediate annuity cannot be considered as part of your estate. This can also be used as an estate planning tool- but consultation with an estate planner is required.

The main point is to find out how much money you will need when you retire, and find the right investment vehicle for you to help get you there. Of course, this vehicle will be different for everybody depending on their retirement needs; however, annuities are a great retirement tool.