Annuities

An investment’s return is what most people analyze each year. However, what really counts is how much you hold on to after taxes. After all, that’s what you get to spend. If you’re shopping around for CDs, you may want to look at an alternative idea that will let you keep more of what you earn.

Suppose that you are considering a five-year jumbo CD. The certificate’s earnings may push your provisional income over the government’s threshold (provisional income is the income calculated by IRS to determine if and how much of your Social Security income becomes taxable). The result is that more of your Social Security check will become taxable when you add interest from CDs. 

The solution could be an immediate annuity that will pay you an income for five years (five-year certain). Part of that income will be taxable, while the rest considered a tax-free return of your investment. At the end of five years, the payments stop. To replace the funds you put into the immediate annuity, you would invest in a five-year fixed annuity. Interest earnings on the fixed annuity are tax-deferred, and not counted towards the government’s threshold of taxation of Social Security income.
  
The result is that you would have one investment that is partially taxable and another that is tax-deferred, therefore your provisional income should go down. With the right planning, you may possibly reduce it to the point that you would not have to pay income taxes on any of your Social Security benefits. Additionally, a decline in your adjusted gross income will lower the floor on medical expense deductions, and miscellaneous itemized deductions.

When the five years are up, you could remove funds from the fixed annuity, pay the income annuity tax, and purchase another immediate annuity. Or you could annuitize the fixed annuity for lifetime payments.
Much of this strategy depends on your current tax bracket, itemized deductions, exemptions, and income requirements. Therefore, in order to make sure this is an appropriate solution for you, we would need to include these factors in your analysis.

Ask your retirement advisor to give you an analysis of a split annuity.

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Safety is a relative term because what is safe to one person is risky to another.  For instance you may consider a U.S. Treasury bond one of the safest investments since it is backed by our government. But a true skeptic might say, “Suppose the U.S. government went belly-up? The bond could then be worthless.” Or he might argue that the government’s unabated printing of money will debase our currency making dollar investments worthless. Yes, he could have a valid point. However, putting the extremes aside, safety is one of the top reasons that people buy fixed annuities.

There are several independent rating agencies that regularly assess the financial strength of insurance and annuity companies. Included are A.M. Best, Duff & Phelps, Moody’s, Standard & Poor’s, and Weiss Research. These firms will give you an evaluation of a company’s balance sheet strength, operating performance, and ability to meet ongoing obligations. In addition, all companies must follow the “legal reserve system.” This is a set of rules on asset management, accounting, and reserve requirements.

The reserve requirements assure that funds are set aside specifically to protect against an insurance company’s portfolio losses. Furthermore, insurance companies are state regulated. And all 50 states, the District of Columbia, and Puerto Rico have guaranty associations to which licensed life and health insurers must belong. When states determine that an insurer is insolvent, a mechanism within the association protects the policyholders and can possibly help pay the claims against financially-troubled insurance companies.

This does not mean you should throw caution to the wind.  Weiss Ratings are the most conservative and rate the short term liquidity of the insurance company if they had a short term “run.”   Weiss Rating of B or better is strong.    AM Best ratings are the least useful as over the years, they have freely given out A ratings to companies that had not earned such.

When First Capital failed, an annuity company in Southern California that had a high percentage of junk bonds in its portfolio, it had an A rating form Best.  And although no investors lost any money because of the State’s efforts to have another insurance company assume First Capital’s, there was a moratorium on withdrawals and investors could not access their accounts for 5 years.

A good source of annuity safety ratings is to consult the “Comdex ratings” given by Vital Signs.  A Comdex rating of 80 or better is very good. An experienced retirement consultant will have access to Vital Signs reports.

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Do you want to be a dependent senior citizen?

You likely are according to this conclusion by the Economic Policy Institute, “For the typical person approaching retirement, the value of expected future Social Security retirement benefits represents the largest single source of wealth.”  While this may be true, it’s a situation you don’t want to be in–dependent on the government and its political whims to determine your level of senior citizen retirement income.  The more you can control and rely on your other sources of retirement income, the more independent you will be.

Let’s discuss the ways in which you become independent with respect to your senior citizen retirement income.

If you have a home, use a reverse mortgage when you need it. Most seniors are simply ignorant about how reverse mortgages work and then act out of ignorance.  The other option is to find out how they work.  A revrse mortgage simply allows you to tap the equity in your home as an income source.  Right now, your home equity earns nothing, 0%.  Would you keep money in the bank at 0%?  Of course, when you die with a reverse mortgage, the equity in your home will be reduced to heirs.  But so what?  Shouldn’t you live more comfortably and enjoy a higher level of  senior citizen retirement income?  Don’t get a reverse mortgage until you need it as the payments are larger at older ages.

Another option is to annuitize your assets.  Here again, the idea is that rather than leaving an inheritance, you get the money to enjoy during your lifetime by consuming principal.  The risk in spending principal is that the principal could run out before you do.  But what if you could enjoy more senior citizen retirement income and not worry about running our of principal?  That’s exactly what an immediate annuity allows.  An insurance company will guarantee a lifetime income in exchange for a single deposit. For example, a 72 year old woman, for a deposit of $200,000 would receive a lifetime monthly income of $1590 (11/25/08).  This is likely more than the social security check received.  While this is not recommended for all of your assets (the payment is fixed and will not adjust for inflation), it makes good sense for a portion of your assets to supply senior citizen retirement income that you cannot outlive.

If you worry about leaving funds to your favorite charity, a goal you may have had for some time, you can use the option above in the form of a Charitable Gift Annuity.  Rather than deposit finds with a commercial insurance company, you deposit the funds with a charity and the charity provides a lifetime income.  The amount may be less than the commercial annuity so check and compare.  Additionally, you get a tax deduction that could shelter your income and reduce your tax bill for up to 6 years.

These are but a few ideas to increase Senior Citizen Retirement Income.  Consult an experienced retirement advisor for additional recommendations.

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Do you find yourself worrying about your finances? While you may think of your situation as unique, you may in fact be among the majority of seniors wtih financial worries.

A recent survey by the publishers of Senior Market Advisor Magazine revealed several seniors’ responses to the question “How much do you worry about money?”

A little                           45%
More than I should        27%
A lot                              20%
Keeps me up at night      5%
Never                              3%
Source: Senior Market Advisor, Senior Survey 2005 (July 2005)

If the same poll were taken today, there would likely be many more who answer that financial worries are at the top of their worry list.

Notwithstanding these statistical findings, financial worries do not have to control you.  A more secure retirement is possible, with smart and prudent financial planning solutions to these common retirement worries:

Retirement Savings Shortfall
Upon reaching retirement, some seniors are surprised to discover that their retirement savings will come up short–an obvious source of financial worry. Instead of pursuing leisure activities, they find that they must curtail their spending habits in order to make their savings last. However even in retirement, you can put your savings to work for you with investment strategies that are designed to help you achieve your growth and income objectives. For example, do you find that your investments are heavily concentrated in CDs and bank account deposits?  Although these investments are often a very good source of liquidity and are insured by the FDIC, an over concentration in these safe investments could expose your portfolio to inflationary risks as they simply don’t pay enough interest. 

Loss of Investment Value
If you’ve owned stocks, recent problems do not get any worse to cause financial worry. Unfortunately, market corrections are a fact of life and can show up at any time. There are things that can be done to help you weather these storms: 
1) diversifying your portfolio,
2) rebalancing your holdings so that stocks never exceed a pre-determined percentage of your portfolio, and
3) following asset allocation strategies designed to reduce your exposure to market risk.  Although asset allocation does not guarantee against the risk of loss in a declining market, it can help reduce the overall volatility of your portfolio. Has your portfolio been reviewed lately? If not, now might be a very good time to do this.

Another key is divide your retirement savings into baskets.  Your most conservative pot, money market and CDs is money you will use in the next 3 years.  The next pot, maybe bonds and preferred shares are to be used in the next 3to 6 years. The next pot, say balanced mutual funds, in the next 6 to 9 years, and stocks or equity funds, to be used in 10 years or more.  Using this approach, even when the market does decline, your stocks have 10 years to recover and won’t destroy your retirement income planning.

Annuitize Your Savings
This is a common worry among many seniors, but one with practical solutions. For instance, buying a fixed deferred or immediate annuity with lifetime income guarantees could help to provide you with a reliable and steady source of cash flow for your retirement.

Annuities are long-term investments designed for retirement purposes. Withdrawals of taxable amounts are subject to income tax and, if taken prior to age 59½, a 10% federal tax penalty may apply. Early withdrawals can also be subject to surrender charges. Annuity guarantees are also backed by the claims-paying ability of the issuer.

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As a retiree, you may have Social Security income and some pension income too. But you may want an additional but assured income to round out your financial planning for retirement. You have some investment money you can generate income with but you are leery of losing your principal because you may have to rely on that income for a long time.  What is an appropriate strategy for generating income but preserving your principal?

You could use a certificate of deposit (CD). It is federally insured. The interest rate you will get depends on how long you tie up your money in the CD. A longer term CD typically produces a higher rate. CD’s are conservative securities representing the lower region of interest rate offerings.

Nevertheless, at, say, 5% interest you can take $5,000 per year and preserve your $100,000 principal.  This interest income is fully taxed and you would be left $3,300 with under a 28% tax bracket. Let’s try a better strategy…

A strategy that can give you more income–and will also tie your money up for while–uses a Split Annuity. Actually a Split Annuity is not an annuity policy. It is simply a combination of two annuity products. A single premium tax deferred annuity (SPDA) and a single premium immediate annuity (SPIA). 

What you do here is split your investment to pay the single premium for each of two annuity policies.  You will pay the single premium immediate annuity to produce an immediate income stream guaranteed for a certain period of time. At the end of the term, all investment in this annuity will be used up.

With the remainder of your investment, you will pay the single premium of the deferred annuity for the same term. The purpose of the deferred annuity is to grow this single premium payment back to at least the amount of your full investment amount before the split.

So at the end of the term, you will have received a yearly income from the immediate annuity and have replenished your investment with the deferred annuity. But you will need an interest rate on each to achieve this. Annuities do not carry the federally insured protection of CD’s, but fixed annuities are regulated as insurance products and can offer guaranteed rates. This lends a good deal of security to your investment.
As a hypothetical example, let’s conservatively assume that you can get interest rates at least comparable to the CD analyzed above . We will appropriately split the same $100,000 investment and attribute a 5.0% rate for the immediate annuity, and 5.0% for the deferred annuity premiums.  The table shows you the hypothetical investment split and results for a term of eight years.

Even for annuity rates comparable to the CD, the immediate annuity leaves you with a yearly after tax income of $4,713 compared to the $3,600 of the CD – almost 31% more income. Note that no fees or expenses were incorporated into the annuity values illustrated, as typically, in the case of fixed annuities, the stated interest rate is net of commissions and fees. However, if additional expenses or costs were present, they would reduce performance.

Do you want to understand more about annuities?  Order you FREE copy Annuity Owner Mistakes.

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You can exchange one retirement annuity for another, but you as a retiree need to watch out for what you may lose in the process. Often when you have one investment and see a similar but better version of it, you wonder if you can ‘upgrade’ to the new and improved version. Generally, whenever you liquidate an investment or retirement annuity, you need to pay taxes on any gain. If you buy another investment, your cost of the new investment will be its tax basis until it is sold in the future to determine gain.

However, in the case of two retirement annuities of ‘like kind’, the U.S. tax code, section 1035, allows you to simply exchange the two ‘like kind’ contrcats–if circumstances allow–so as not to have to pay tax until the latter investment is sold or pays out. In the case of retirement annuities, you need to be aware of what/how your ‘new and improved’ annuity may be different from your ‘old’ annuity.

Section 1035 allows you to exchange an existing annuity contract for a new annuity contract without paying any tax on the income and investment gains in your current retirement annuity. These tax-free exchanges, known as 1035 exchanges, can be useful if another annuity has features that you prefer, such as a larger death benefit, different annuity pay-out options, or a wider selection of investment choices.

You may, however, be required to pay surrender charges on the old retirement annuity if you are still in its surrender charge period. In addition, a new surrender charge period generally begins when you exchange into the new annuity. This means that, for a significant number of years (as many as 10 years); you typically will have to pay a surrender charge (which can be as high as 9% of your purchase payments) if you withdraw funds from the new annuity prior to term, and if the withdrawals exceed the annual allowance.
Further, the new retirement annuity may have higher annual fees and charges than the old annuity, which will reduce your returns.

So if you are thinking about a 1035 exchange, compare both retirement annuities carefully. Unless you plan to hold the new annuity for a significant amount of time, you may be better off keeping the old annuity because the new annuity typically will impose a new surrender charge period.

Also, if you decide to do a 1035 exchange with your retirement annuity, get the right retirement help and talk with a qualified tax professional to make sure you don’t violate the provisions of IRS section 1035. While insurance agents sell retirement annuities, few are well schooled in the more esoteric tax aspects.

Note: Annuities once annuitized cannot be surrendered for value. Income from retirement annuities is taxed as ordinary income and withdrawals prior to age 59½ are subject to a 10% penalty. Income from annuitization is taxed partly as ordinary income and partly as return of capital. The purchase of annuities incurs commissions and potential surrender charges. Any guarantees are based on the claims-paying ability of the insurance company. Retirement annuities should be considered long-term investments.

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Stability and safety are important to many seniors, and these are only two of the reasons why immediate annuities are popular retirement income choices. A check arrives every month and part of the annuity income is considered a tax-free return of your principal. As long as the immediate annuity company is financially sound, the payments will continue for the life of the contract (annuities are guaranteed by the claims-paying ability of the issuing company).  You can get an estimate of monthly income using the immediate annuity calculator.

However, consumers sometimes believe that immediate annuities are illiquid, irreversible investments, and cannot provide for future lifestyle changes. Nonetheless, there are some immediate annuities with options that may add flexibility to your financial plan.

Immediate annuities can possibly include an option that would allow you to receive extra cash at specific anniversary dates. For example, this might be at the 5th, 10th, or 15th anniversary of your investment. Exercising this option will reduce your current payments (the distribution may be fully taxable, so consult with your tax professional).

Suppose you needed money to cover an emergency, like paying for caregivers or a home repair. Some immediate annuity companies will let you take up to six payments at once. You would not, however, receive checks for the following six months (payments may be fully taxable so consult with your tax professional).

You may also have the ability to provide a cash benefit from your immediate annuity to your heirs. This would be a pre-determined percentage, such as 25% or 50% of the amount of your initial investment. Selecting this option will reduce your monthly annuity checks and may have tax consequences.

Another option, immediate annuity commutation, allows you to cash in the remaining “balance” on your immediate annuity at a discounted buyout.  Yet another option insures that all of your principal is recovered for your heirs in the case you pass away before you personally recover your entire premium.

Immediate annuities can provide a lifetime income you cannot outlive and also provide flexibility of which few consumers are aware.

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