IRAs and annuities are growing in popularity as retirement investment options, according to recent surveys, but they can have serious disadvantages.
Last year, four out of 10 U.S. households had IRA accounts. That's up from 17% two decades ago, according to an ICI Research survey. But they can be bad for beneficiaries if your client has a very large account.
Investment in annuities, touted as offering a potential guaranteed income stream, also continue to grow with sales up 10% in the second quarter of this year.
“Annuities have several dark sides, both during your lifetime and for your beneficiaries,” says wealth management advisor Haitham Ashoo, CEO of Pillar Wealth Management. “My business partner, Chris Snyder, and I wouldn’t recommend investing in them.”
Putting large amounts of money in either annuities or IRAs can have serious tax consequences for heirs, adds attorney John Hartog of Hartog & Baer Trust and Estate Law. “If you want to ensure beneficiaries get what your client saved, you need to take some precautions,” Hartog says.
Ashoo, Hartog and I (a CPA) offer these suggestions:
Take stock of your client’s assets; they could be worth more than they think.
If your client’s estate is worth more than $5.25 million (for couples, $10.5 million), their beneficiaries face a 40 percent estate tax and federal and state income taxes. It can substantially deplete the IRA.
To avoid that, take stock of their assets now – they may have more than they realize when they take into account such variables as inflation and rising property values. Be aware of how close to that $5 million/$10 million benchmark they are now, and how close they’ll be a few years from now. Consider vacation and rental properties, vehicles, and potential inheritances as well.
Also, take advantage of the lower tax rates enjoyed today, particularly if they’re going to skyrocket after death. A lot of people want to pay zero taxes now and that’s not necessarily a good idea. For instance, if they’re at that upper level, consider converting their traditional IRA to a Roth IRA and paying the taxes on the money now so their beneficiaries won’t have to later.
No matter what the estate’s value, avoid investing in annuities.
Wealth management advisor Ashoo warns annuities, offered by insurance companies, can cost investors an inordinate amount of money during their lifetime and afterward.
“Insurance companies try to sell customers on the potential for guaranteed income, a death benefit paid to beneficiaries, or a ‘can’t lose’ minimum return, but none of those compensates for what you have to give up,” he says.
That includes being locked in to the annuity for five to seven years with hefty penalties for pulling out early; returns that fall far short of market investments on indexed annuities; high management fees for variable annuities; declining returns on fixed-rated annuities in their latter years; and giving up your principle in return for guaranteed income.
“If you own annuities and have a substantial estate, there are smart ways to unwind them to minimize damage,” Ashoo says.
Consider spending down a tax-deferred IRA early.
If your client is in the group with $5 million/$10 million in assets, it pays to go against everything you’ve been taught and spend the IRA before other assets, says attorney Hartog.
“It’s a good vehicle for charitable gifts if you’re so inclined. And if you’re 70-and-a-half or older, this year you can direct up to $100,000 of your IRA-required minimum distribution to charity and it won’t show up as taxable income,” Hartog says. (That provision is set to expire next year.)
Your client might also postpone taking Social Security benefits until they’re 70-and-a-half and withdraw from the IRA instead. “That will maximize your Social Security benefit – they’ll get 8 percent more.”
Finally, anyone who has accumulated some wealth will do best coordinating their financial planning with a team of specialists.
As a CPA, I’m focused on minimizing taxes; wealth management adviser Ashoo’s concern is the client’s goals and lifestyle; and lawyer Hartog minimizes estate taxes.
“We get the best results managing tax consequences and maintaining our clients’ lifestyles by working together,” Hartog says.