Is Your Annuity in the Wrong Bucket? with David McKnight

99.5% of all annuities are not in the right bucket. There are many reasons to use an annuity: they can be safe and productive, they safeguard against market risk while participating in the upward movement, and many people use them for a guaranteed stream of income.

The alternative to annuities for creating a stream of income is the stock market but that approach comes with a set of rules including the previously discussed 4% Rule. When you factor in present conditions, the 4% Rule no longer holds true and it’s now more like the 3% Rule.

In order to live your target lifestyle with the stock market strategy, you would typically have five options: you can save more, spend less, work longer, die sooner, or take more risk in the stock market. Most of those options don’t appeal to people, but there is an alternative with annuities.

One of the more common ways of solving this problem is using a single premium immediate annuity. The appealing part of this option is that you don’t need nearly as much money upfront to live your target lifestyle. The downside is that if you die early, that money is gone.

Some people will use a fixed-index annuity, where the growth of the annuity is fixed to the growth of an index in the stock market.

The trouble is that nearly every single annuity is in the tax-deferred bucket. Let’s say you decide to draw an income from your annuity. It’s going to feel like it’s coming from a pension and that means it will be exposed to tax rate risk. If tax rates go up, the portion you get to keep goes down.

The reason people are getting a guaranteed lifetime stream of income is they want a guarantee that it will cover their lifestyle expenses when coupled with their social security. If tax rates go up, and we expect them to, that stream of income will not cover your lifestyle expenses and that means you will have to spend down your other assets much faster than you expected

Those spare dollars are meant to cover aspirational expenses or shock expenses and spending down this pool of resources will cause you problems down the road.

Like a pension, if you draw from an annuity in your tax deferred bucket, it will count as provisional income and counts against the threshold that determines if your social security gets taxed. When your social security gets taxed, you run out of money 5 to 7 years faster.

If most annuities are in the tax-deferred bucket, this will force people to pay tax on their social security in a rising tax rate environment. They are going to keep less of their income than they thought they would, and it’s going to force them to spend down their non-annuity assets that much faster.

There is a way to get the annuity in the tax-free bucket. When most people retire with 401(k)’s or IRA’s and they roll them into an annuity, they typically get stuck. This is why it’s crucial to use an annuity that allows you to use the Roth conversion option at your leisure.

There are four companies that allow you to take advantage of an internal Roth conversion feature that allows you to shift your annuity over to the tax-free bucket.

Having an annuity in the tax-free bucket is much closer to the idea of a guaranteed stream of income and it allows you to take much more risk in the stock market. You won’t be as constrained and can allow the market to go up and down without being exposed to the same level of tax rate risk or sequence of return risk.

There are a number of benefits to having your annuity in your tax-free bucket as opposed to being stuck in the tax-deferred bucket. If you’re contemplating getting an annuity, ask your advisor if you’re getting one that will have to stay in the tax-deferred bucket. Specifically ask if the annuity allows for internal piecemeal Roth conversions.