Divide and Conquer

Prepare yourself for a shocking statistic. According to a recent survey by Allianz Life Insurance Company, 61 percent  of Baby Boomers fear running out of money in retirement more than they fear death. Reclaiming the Future: Challenging Retirement Income Perceptions, conducted in May 2010 with more than 3,200 Baby Boomers ranging in age from 44 to 75, also found that 36 percent of those surveyed have no idea how long their retirement nest egg will last.

These profound worries are not unexpected given that longevity continues to increase, interest rates remain at historic lows and portfolios are still recovering from the Great Recession. In fact, with diminished prospects for long-term growth and market volatility a new fact of life, many Baby Boomers are rethinking retirement, even wrestling with the notion that they may need to supplement their retirement income with a part-time job.

There is no magic solution to the retirement income puzzle. However, rather than playing a risky game of portfolio catch-up, it may be more realistic for some investors to consider the role annuities, especially split annuities, can play in creating a dependable retirement income stream.

“Gimme Shelter”

Annuities have a well-deserved reputation as complex products that are often aggressively sold. However, in its simplest form, an annuity is a contract between you and an insurance company. Annuities generally fall into two categories: immediate income and tax-deferred. Immediate income annuities provide an immediate, tax-advantaged and guaranteed stream of income in retirement in exchange for a lump sum of money. Tax-deferred annuities enable you save tax-deferred for retirement even if you have fully funded your 401(k)s and IRAs. Each type of annuity is offered at fixed or variable interest rates.

Annuities may be of the greatest benefit to investors in high marginal income tax brackets who expect their income will be significantly lower in retirement. In addition to providing peace of mind through income guarantees, because the federal tax code permits cash deposited in insurance contracts to grow tax-deferred, annuities also can deliver a range of potential tax advantages. For example, a portion of the monthly payment from the immediate annuity is considered return of premium and, therefore, not taxable and earnings from the tax-deferred annuity are not taxed until withdrawal.

A split annuity, typically comprised of a single premium immediate annuity and a single premium deferred annuity, is of particular interest. The combination of products enables you to both generate a stable monthly income stream and restore your original starting principal over a set period of years.  That is, ideally, by the time your monthly payments are depleted, the deferred annuity, which grows on a fixed interest basis, will be fully restored to your original starting principal. At that point, you can choose to restart the process at the current prevailing interest rates.

A triple split annuity, comprised of an immediate annuity and two deferred annuities, may be an even better option for some investors. In addition to providing a reliable income stream and returning your principal, there are tax advantages as well. You could put $170,000 into one deferred annuity and $347,881 into another deferred annuity. At 6% the $170,000 would grow to $262,833 which when annuitized to produce the $3,482.00/month, and would have an exclusion ration of 0.7882. In other words, 78.82 percent of the monthly income ($2,744.55) would be considered return of premium and not taxable. Obviously, these numbers are for illustrative purposes and they would vary for different investors and companies. The point, however, is that there is a way to improve upon the traditional split annuity.

Interestingly, some investors use the immediate portion of their split or triple split annuity to pay fixed expenses on a tax-advantaged basis. In addition to being directed to pay a fixed mortgage payment, long-term care premium or college tuition, the reliable monthly income could also help fund an income gap between early retirements and when you begin to collect Social Security benefits.

Increased use of annuities

With 76 million Baby Boomers born between 1945 and 1961 at or closing in on retirement age, creating secure retirement income streams is one of the primary challenges facing our nation. Historically, those saving for retirement have focused on growing their nest eggs. However, especially in today’s uncertain market, many investors are focused on protecting their nest eggs and getting as much as possible out of their assets once they start making withdrawals. Accordingly, annuity sales likely will continue to increase.

Is an annuity right for you? To decide, you must evaluate not only investment details from interest rates to fees and mortality rates, but the underlying strength of the insurance company. Although a multitude of online  tools can support your analysis, this decision is best made after a frank discussion with your trusted advisor about your income needs and estate planning goals. If you are interested in exploring how an annuity could enhance your retirement income stability while possibly reducing taxes, we recommend that you discuss this concept with an advisor who is not compensated by commissions so he or she can give you an objective point of view.

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