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Tax-deferred retirement saving, without a 401(k)

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The single most powerful feature of an annuity is tax deferral, according to Mitch Caplan, CEO of Jefferson National, not features like guaranteed income and riders. “Our philosophy is the most powerful thing you can provide the advisor and their client is the ability to save in a compounding way utilizing tax deferral,” he said.

Investors can get tax deferral through an IRA or 401(k), as well as other products like health savings accounts and 529 plans, but “given that they have limitations in contribution amounts, it’s pretty easy to start maxing out on what you could do in terms of being able to build for the future,” he told ThinkAdvisor in an interview.

Using an “annuity chassis” to provide tax deferral would work, he said, “but only if it was low cost.”

“A traditional asset allocation model probably provides you with 100 to 200 basis points in additional returns through tax deferral annually,” Caplan said. “That means the cost you pay for that tax deferral has got to be very low in order for the benefit to accrue to you.” However, in the mid-2000s, “most companies that were providing tax deferral through an annuity structure charged on average 130 basis points. So in many cases it was wiping out either some or 100% or more of the benefit associated with tax deferral.”

As a result, the industry moved away from selling the tax deferral aspects and focused on benefits like riders, lifetime income guarantees and death benefits. “They needed to sell on the sizzle of something,” Caplan said.

Jefferson National launched Monument Advisor, an investment-only variable annuity, in 2005. It charges a $20 a month flat fee, Caplan said, and the average account balance today is $250,000. “At a quarter of a million dollars when they’re paying $240 a year, it costs them about 10 basis points. At 10 basis points, it preserves the value of tax deferral.”

It’s All About Education

Caplan said that what the advisors Jefferson National serves really want is education and information. “They generally speaking have little to no interest in being marketed to,” he said.

Ten years ago when the firm first launched its IOVA, “when you tried to discuss the use of annuity as a tax planning vehicle with an advisor, they just didn’t believe that such a thing existed,” Caplan said. “Today, advisors definitely understand that there is this construct of using an annuity chassis to provide an investment-only variable annuity, and it is about the power of tax deferral.”

In educating them about using an annuity as a tax-planning vehicle, Caplan said the conversation revolves around asset location and asset selection.

“What is the appropriate amount of your client’s assets that should be put into a vehicle for saving and building wealth for retirement?” he said. Clients of the advisors his firm works with have already maxed out their IRA and 401(k) contributions, he said, because those accounts are the “first line of defense regardless of where you are” in the retirement planning life cycle.

Once advisors determine the appropriate percentage of a client’s account to defer, they have to find the right products.

“You should not be putting in that tax wrapper an S&P index fund or an ETF,” he said. Caplan recommends using variable insurance trusts, “which are effectively ’40 Act mutual funds cloned into a separate product.”

Ultimately, advisors should pick funds that “by their very nature are tax inefficient; either they’re generating high current income or they’re tactically traded so it’s creating short-term capital gains, which is the same as being taxed at an ordinary income rate. Or anything that has high dividends associated with it.”

Planning for the Ages

“The country as a whole has been challenged for decades with being overleveraged and undersaved,” Caplan said. “It’s a broader issue for the industry and the government to make sure people change their behavior to become more accountable and start saving early to protect themselves as they move toward retirement.”

Millennials may not have enough savings or income for this strategy to work for them yet, but Caplan said they should at least start thinking about it. “The single most important thing that [millennials] can do is recognize that you need to save. A big part of this behavior is on you. You have all these expenses: You’re in your first or second job, you’re just starting to build cash flow, you’ve got student loans.”

Just committing to saving a portion of every single paycheck is a good start, Caplan said. “That will put you in a better position, not just for your future, but even in the short term in case you need it.”

Caplan stressed the value of a 401(k) specifically because employers often match employees’ contributions. “It is imperative to use things like that, and if your company doesn’t have that available to you, consider using independently or in addition [to the 401(k)] an IRA.

“It seems like a long time until retirement. It seems like an amorphous concept. Rather than being focused on that, focus on things like saving,” he suggested to young investors.

Caplan said conversations about retirement planning are easier with Gen X clients because the concept of retirement is “less amorphous.”

“They’ve been at a series of jobs for a number of years. They’re starting to build savings. It’s saying, ‘Have you and are you continuing to do things like contribute to your 401(k)? Have you maxed out on 401(k)s? Because you may have begun to have a family, do you think about things like 529 plans for educating your kids? Have you utilized health savings accounts as a tax-efficient way to cover all your medical expenses?’”

This age is also when clients start meeting their retirement account contribution limits and need other ways to save, he said. For clients who can live without that income until they’re 59 1/2 and can withdraw it without incurring an IRS penalty, an IOVA might be able to meet their needs.

Then, when clients turn 59, it “effectively becomes a liquid tax-deferred brokerage account,” Caplan said. “They have access to tax deferral, but there’s no lock-up because they’re older than 59, so they’re able to move money in and out with no impact from a penalty perspective, and yet they can still get the benefit of compounding.”

For boomers, retirement is very real. “They’re starting to think about how many years until they retire,” Caplan said. “They’re also at a place in their families where kids are beginning to go to college or graduate school, so they’ve got all of those pressures.”

He encouraged advisors to urge their boomer clients to continue investing in their retirement accounts, but said this is the time to include legacy planning in conversations. “’Do I want to think about a trust? What other vehicles can I use that will help me?’”

Caplan said that IOVAs can be included in a trust so that it continues to work for the client during their lifetime, as well as for the family after the client’s death.

There are two categories of retirees, he said. Some are withdrawing money from their retirement accounts to live on, and others “don’t really need it and are more concerned about passing it on through the trust to the next generation in a way that is as efficient and effective as possible.”


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