Annuities and Tax Planning Boost Retirement Income and More

You have worked hard to build up your retirement savings. You and your family live in a beautiful home. Yet, you still worry at least a little about whether you have enough money to really enjoy yourself, and to pay the bills for the rest of your life, including the late-in-retirement expenses for long-term care or a health crisis.

Perhaps that’s because other than Social Security, we rely largely on ourselves for building savings and the plans to access those savings to the best effect when we retire. The IRS, however, has spent some time on this issue, too, and that may prove helpful.

IRS rules encourage lifetime income protection through annuities

The IRS actually offers tax incentives that can help you provide lifetime income on a tax-advantaged basis.

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Tax rules encourage investors to take care of their retirement plans through the purchase of different forms of lifetime annuities. Now, it’s OK to be skeptical about supposed government largesse, but please read the following information before making up your mind.

• Single premium immediate annuities (SPIA). A portion of each annuity payment is considered a tax-free return of principal when purchased from your personal (after-tax) savings. In today’s market, for a female at age 70, only 22% of a life-only payment is taxable until her age 85.
• Fixed, variable or index deferred annuities (DAs). These annuities can be exchanged tax-free to a SPIA or deferred income annuity (DIA) with any taxable gain spread over future annuity payments. And partial exchanges from DAs are permitted.
• Qualifying longevity annuity contract (QLAC). An IRA account holder can take up to $200,000 of the account and by purchasing a QLAC can defer RMDs on that amount until age 85, when lifetime annuity payments begin.

At the same time that you’re saving money on taxes, these annuities are generating more income, and a larger portion of your total income is guaranteed for your lifetime. By the way, with an improved income plan, you may be able to delay claiming Social Security benefits and grow lifetime income from that source. Or you can use a portion of the tax savings to provide beneficiary protection on your annuity payments.

Tax benefits from adding lifetime protection to your plan

Let’s go back to our sample investor, a woman at 70, whose current portfolio is invested as below. She’s following the “100 minus age” rule with a 30% allocation to stocks.

• $750,000 in personal savings: $225,000 invested in high-dividend stock investments (30%) and $525,000 invested in fixed income investments (70%)
• $750,000 in a rollover IRA: Invested in a balanced portfolio (30% in stock investments)
• Her home is worth $1 million free and clear but is not part of her income plan

Her first-year income goal from these savings is $96,000, or $8,000 per month. And she wants her income to grow by 2% a year as a hedge against inflation. That’s a pretty aggressive starting income goal of over 6% of her savings.

To achieve that goal beyond her $5,600 from monthly interest, dividends and IRA withdrawals, she needs to withdraw another $2,400 per month, probably from her rollover IRA account. With this approach, she runs the risk of running through her IRA savings.

To do her taxes, we need to know her other income sources: She also has $36,000 in annual Social Security benefits and $26,000 from a pension.

If she leaves her plan as is, she is paying an estimated $27,000 in first-year taxes and retaining a large portion of the lifetime income risk. That’s not what the IRS intended.

Investor considers Go2Income planning

She’s open to considering the Go2Income planning method that includes income annuities to lower her taxes and her risks. With the additional income from annuity payments, she’s reducing her income risk and lowering the extra withdrawals she has to take to meet her $8,000-per-month goal to about $1,000 per month. She’s also increased her safe income from 32% to 49% of the total income from savings.

And, by bringing in the guaranteed lifetime income of the annuity payments, she’s taking advantage of the IRS rules and lowering her estimated first-year taxes from $27,000 to $21,000.

The gotcha of this plan to some is that to get the benefits of an annuity’s lifetime protection, and a higher payout, you have to give up access to the value of the annuity, otherwise known as liquidity. (If you had full access along with the annuity, you couldn’t get the benefit of the longevity credits, which is worth 15% or more in cash flow.) You can get a quote here on how much income you can get with a SPIA.

Here’s one possible answer to the gotcha. There’s an asset hiding in plain sight that can take these tax advantages and income protection and deliver additional income and liquidity. It’s your home, and the vehicle is a home equity conversion mortgage, or HECM. Let’s see how you could build it into your plan.

Using an HECM as part of HomeEquity2Income

An HECM is a type of reverse mortgage backed by the government that allows homeowners to convert part of their home equity into cash. We’ve discussed the features of an HECM in earlier articles, but the one thing we haven’t emphasized is the tax-free nature of the HECM drawdowns. Many Boomers have 25% to 40% of their net worth in home equity, and most are not accessing it for supplemental retirement income.

Integrating HECM into a new approach to retirement income called HomeEquity2Income (H2I) allows clients to access their home equity, reduce their taxes and increase their financial flexibility. See my article How to Add Home Equity to Your Retirement Income Planning to learn more about this.

H2I combines an HECM and a QLAC to provide an efficient source of lifetime income and liquidity for Baby Boomers, particularly those looking to age in place and concerned about the costs of bringing in care providers or upgrading their residence. H2I allows them to access it tax-effectively without selling or renting their house.

Compare our investor’s plan with H2I to the original plan

Here are the key benefits of the plan with H2I vs her original investment-only plan:

• No extra drawdown from our investor’s retirement savings is required. About $1,000 per month is coming from an HECM
• The percentage of income that is considered safe increases from 32% to 68%
• Liquid savings at age 85 to meet unplanned expenses are increased by over $500,000
• Estimated first-year income taxes are reduced from $27,000 to $15,000

The accumulated value of reinvesting those tax savings over 15 years for our sample investor is an additional $250,000.

Bottom line: Lower taxes, lifetime income, liquid savings — and even more

It may seem like a circuitous path to use tax savings combined with an annuity’s lifetime protection and further tax savings that come from accessing the value in your home. But with the help of the IRS, it all makes sense. If you need help in understanding this process, our Go2Specialists can explain in more detail.

Visit Go2Income to put together your own plan to step up your lifetime income and liquid savings. A Go2Specialist will be available to answer questions and guide you through the process.

Related Content

• Is Your Retirement Solution Hiding in Plain Sight?
• How to Cut Your Taxes as Short-Term Interest Rates Come Down
• For Longevity Protection, Consider a QLAC
• How a Fixed Index Annuity Can Manage Retirement Income Risks
• Retirees: Worry Less About Markets, Long-Term Care and Taxes