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December 20, 2012 at 06:00 AM
With company pensions nearly extinct, retirees have even more reason to make sure they are reaping the full benefits of the Social Security system. Often confusing to retirees and soon-to-be retirees, most clients do not realize that powerful strategies exist to maximize their Social Security payments. Armed with these optimization strategies, financial advisors can empower their clients as they navigate the retirement income jungle.
Quite simply, a retiree’s Social Security payment is higher if he or she delays the payment starting date. Take, for instance, someone who elects to begin their payments at age 62, which is the minimum required age. Beginning at 62, the maximum monthly benefit for 2012 is $1,855. Delay the start of Social Security payments until age 70, and the same person will now receive $3,266 per month.
While delaying benefits will eventually provide a boost in annual income, the challenge then becomes filling the income gap until age 70. Fortunately, an annuity can solve this problem. A “term certain” income annuity, either a SPIA (single premium immediate annuity) or DIA (deferred income annuity), will provide the client with guaranteed income during the gap, or later if desired.
Tax treatment
In addition to the guaranteed income and high payout rate, the tax treatment is often a vastly underrated advantage of annuities. The tax exclusion ratio found in annuities renders only 5 percent to 25 percent of the payments subject to tax, while the remaining 75 percent to 95 percent is the return of principal. Consider if a client tried to fill this gap with growth or yield from stocks, bonds and mutual funds. First, to generate enough income to live on would require an inordinate sum, since it takes a $350,000 investment at 10 percent growth to create $35,000 of annual income. Regardless, this “non-guaranteed” income would also be subject to tax.
If invested in a stock mutual fund, all of a client’s $35,000 annual return on investment is subject to tax. At 15 percent, that tax would be $5,250. Compare that to receiving an annual payout of $35,000 from a SPIA or DIA. In this scenario, the total tax would be reduced from $5,250 to $1,050, assuming an 80 percent exclusion ratio. This tax savings is due to what I call FIBO® (First In/Blend Out). Each annuity payment is a blend of income and principal, unlike other types of investments where income is taxed up front.
With the savings created from lower taxes and delaying Social Security, retirees now have options regarding how they can structure the rest of their investment portfolio in developing their retirement plan. Two possible options for some of the remaining portfolio could be to invest in a deferred income annuity with a 15-year delay and a COLA-adjusted payout or a variable annuity (VA) with a guaranteed lifetime withdrawal benefit (GLWB).
