Money Talk: Should annuities be part of your retirement portfolio?
When building a retirement nest-egg and later transitioning from accumulating wealth to spending it, it makes sense to consider any financial vehicle that offers tax benefits in the accumulation phase as well as an income stream that cannot be outlived in retirement. Annuities offer both features, making them attractive vehicles for retirement planning. As might be expected, however, annuities come with tradeoffs, opportunity costs, base fees and added fees for special features that need to be fully understood to be sure the product being considered is actually the best fit for the objective in mind. If you are considering an annuity to help you accumulate or spend down your nest-egg, here are some key factors to consider.
While saving for retirement, using tax-deferred investment vehicles will boost returns. Annuities, along with traditional IRAs, employer-sponsored retirement plans (401(k)s and 403(b)s), and whole life insurance contracts, fall in this category. Investment earnings that build up in these accounts or insurance contracts are not taxed as earned. Rather, they are taxed upon withdrawal allowing for greater compounding of returns. The benefits of tax-deferred investing are larger for higher income taxpayers and over longer time periods. It takes time for the benefits of delayed tax on investment earnings to accumulate so annuities are best seen as long-term investment vehicles.
Lower tax bracket savers may find the tax advantage to be minimal compared to investing in a taxable brokerage account because qualified dividends and long-term capital gains are taxed at a favorable 15% rate (0% for taxpayers in the lowest two tax brackets). These taxpayers can invest fairly tax efficiently without the tax deferral offered by the annuity contract. Remember that all earnings coming out of an annuity are taxed as ordinary income, not the more favorable rates that apply to qualified dividends and long-term capital gains. Also, unlike traditional IRAs and 401(k)s, annuities do not allow for pre-tax contributions unless the IRA is invested in an annuity contract. In addition, remember that withdrawals from an annuity contract before age 59 ½ are subject to a 10% early withdrawal penalty on the earnings portion of the withdrawal. Note that there is no need to put an annuity in an IRA for tax deferral since an IRA is already tax-deferred. To warrant placement in an IRA, an annuity must offer some benefit in addition to tax-deferral.
One of those benefits may be the promise of guaranteed income for life. This can be greatly beneficial for a retiree since one’s life expectancy is unknowable. To ensure that at least a base level of income is available for a retiree or a retiree and spouse over their joint lifetimes, an annuity can be turned into a monthly retirement paycheck. This type of income stream is called an immediate annuity and can be purchased at retirement using funds accumulated in another type of account (IRA, ROTH IRA, 401(k), taxable account), another annuity, or an existing annuity that has been used to accumulate wealth for retirement can be annuitized (turned into a monthly income). This income will be fully taxable if an IRA or 401(k) is used to fund the annuity contract. If after tax funds are used to purchase the income stream, part of each payment will consist of return of the purchase amount and part of it will be investment earnings. Only the earnings portion will represent taxable income. If a Roth IRA is used, payments will be tax-free if it has been five years since the retiree first made a Roth contribution and they are over age 59 ½.
While immediate annuities offer a way to turn investment risk over to an insurance company (income stays the same regardless of market returns), it takes considerable time for retirees to recoup their initial premiums. Also, retirees who die before their life expectancy will not recover all their premiums, leaving less behind for beneficiaries. Also, these income streams generally do not come with a cost-of-living adjustment built in. Securing an income stream that maintains its purchasing power takes a much larger initial investment. Depending upon the amount of risk a retiree is willing to tolerate, a more favorable outcome in terms of taking withdrawals that keep pace with inflation as well as leaving assets behind for heirs may be achieved by investing funds outside an annuity in a taxable brokerage account or IRA.
David T. Mayes is a CERTIFIED FINANCIAL PLANNERTM professional and IRS Enrolled Three Bearings Fiduciary Advisors, Inc., a fee-only advisory firm in Hampton. He can be reached at (603) 926-1775 or david@threebearings.com.
This article originally appeared on Portsmouth Herald: Money Talk: Should annuities be part of your retirement portfolio?
