We recently met with existing clients for a portfolio “checkup.” The couple, in their mid-60’s, is considering retirement in the next few years and has sufficient investments and retirement assets to meet their financial and family objectives. It is likely the clients will continue to be in the 28% or 33% federal marginal tax bracket during retirement because their taxable income is projected to be between $150,000 and $300,000.
- They are interested in structuring their portfolio to emphasis current income, but they are becoming more concerned about the volatility and risk of the stock market.
- They are active and in good health and expect to live a long time. They feel comfortable planning that at least one of them will be alive into their mid-90’s.
- They have an existing non-retirement annuity that was purchased 15 years ago and want it reviewed. What should he do with this asset that represents less than 5% of their net worth? It has doubled in value since it was purchased.
Annuities: The Good, the Bad and (maybe) the Ugly
Annuities are confusing, complex and misunderstood. They aren’t good or bad. They are a financial tool to help achieve certain objectives. There are many different kinds of annuities, with different features, that may or may not be appropriate.
Tax Deferral is good (but eventually it may be bad):
The clients doubled their money over 15 years and haven’t paid taxes on investment earnings. Earnings will be taxed as regular income at the marginal tax bracket when they are withdrawn. If the client had taken a withdrawal prior to age 59 ½, there would have been an additional 10% IRS penalty tax on earnings withdrawn.
Unfortunately, the clients will eventually pay taxes on earnings when withdrawals begin. The earnings are taxed as regular income (up to 39.6% marginal tax bracket). Had the client invested the same amount in a “taxable account” (not in an annuity or retirement account), it could have been invested in stocks that pay qualified dividends and could have appreciated in value as well. These dividends and gains might be subject to a capital gains tax of 0%, 15% or 20%. Taxable investment accounts can be managed tax-efficiently. Paying lower capital gains taxes at 15 or 20% along the way may be better than paying up to 39.6% income taxes on the earnings from the annuity in the future.
Annuities do not receive a step-up in basis upon death. The gains will eventually be taxed as regular income to the client’s heirs. Heirs may not have to pay capital gains on assets inherited from taxable accounts.
Guarantees are Good (but there is a cost):
Annuities can provide a guaranteed income for life. You can’t outlive an income stream payable from an annuity. If you are concerned about outliving your assets, an annuity might be a great way to supplement your income.
Annuities can provide a guaranteed income floor, despite the fact that they are less liquid and may have less flexibility than other kinds of investments. Most notably, income from an annuity may never drop below a pre-determined minimum. This guarantee is comforting for a retiree that must rely on their assets for current income. Guarantees feel pretty good when the stock and bond markets are volatile.
However, guarantee’s which offer security and comfort, do cost the investor. Insurance companies that offer variable annuities charge an additional 1% to 3% per year, depending on the features selected. These expenses can have a significant impact on account balances that you might want to leave to heirs.
What's the Ugly?
Annuities have a lot of moving parts and are complicated financial products. We find that clients often misunderstand their contract and don’t remember how their annuity works. Particularly, they don’t know how it fits into their overall plan. We have seen clients purchase annuities without a complete understanding of their contract’s liquidity features, expenses, guarantees and tax-consequences. This can be problematic and have a negative impact on their financial plan.
In the client’s situation described at the beginning of this article, our recommendation is to convert the annuity into a lifetime income stream. The clients value the guaranteed income and are willing to have diminished flexibility with an asset that is less than 5% of their total net worth. This seems to meet the client’s need for current income and fits nicely into their overall financial plan.
Annuities are a reasonable financial asset as long the client understands their advantages and disadvantages. They should be used as a financial tool to meet short and long-term financial planning objectives.
Before purchasing an annuity, you should carefully consider its investment options’ objectives, and all the risks, charges, and expenses associated with the annuity and its investment options. Read the prospectus carefully before you invest.
Lincoln Financial Advisors Corp. and its representatives do not provide legal or tax advice. You may want to consult a legal or tax advisor regarding any legal or tax information as it relates to your personal circumstances. This material is not intended to replace the advice of a qualified attorney, tax adviser, investment professional or insurance agent. Peter Raskin is a registered representative of Lincoln Financial Advisors Corp. Securities offered through Lincoln Financial Advisors Corp., a broker-dealer (Member SIPC). Investment advisory services offered through Sagemark Consulting, a division of Lincoln Financial Advisors Corp., a registered investment advisor. Insurance offered through Lincoln affiliates and other fine companies. The content of this material was provided to you by Lincoln Financial Advisors Corp. for its representatives and their clients. 125 Summer Street, Suite 1400, Boston, MA 02110 617-728-7444. CRN-1651144-112516