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September 02, 2004 at 08:00 PM
What You Should Know About Using Fixed Annuities For Retirement Income
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Fixed deferred annuities often are used in the accumulation phase of a financial plan. They offer tax-deferred earnings, safety of principal and yields that are usually higher than comparable alternatives.
Perhaps most important, fixed annuities can be annuitized?i.e., converted to a series of payments to meet basic income needs in retirement.
Uniquely, these “income payments,” as they are often called, can be structured to last a lifetime. But timing maturities and selecting appropriate products can make a big difference in how well they meet investment objectives.
Consider the objective of preserving capital. Many clients seek to preserve capital and live on investment income during retirement. To achieve this, the client will often make a large investment in a deferred annuity that offers surrender charge-free withdrawals of interest. But the withdrawals will be taxable and the investor will lose flexibility.
Let?s say $100,000 is invested in a fixed deferred annuity paying 5%. If earnings are withdrawn annually, the investor will receive $5,000 each year before taxes or $3,750 after taxes assuming the person is in the 25% tax bracket.
A better solution would be to purchase a $50,000 fixed immediate annuity, and two $25,000 fixed deferred annuities. At current rates, the $50,000 will generate about $4,700 a year pre-tax for 15 years; 70% of these payments will be a tax-free return of capital, yielding $4,358 a year after tax. That is $607, or 16%, more than option one.
Assuming 5% interest, both $25,000 deferred annuities will have doubled by year 16. One can be annuitized to provide the same series of payments for another 15 years, 35% tax-free. In year 31, the third will be worth $100,000.
This approach preserves capital, too, but also maximizes income and minimizes taxes.
There are other options. For example, the third annuity could purchase a $100,000 single premium whole life policy providing income to our investor and a tax-free death benefit to heirs. The important point is that more contracts purchased initially will provide more flexibility later.
