Tax-Free Income for Life Preview, Part 2 – How the Traditional Approach to Lifetime Income Annuities Could Spell Disaster for Your Retirement

In the previous episode, David explained the surprising benefits of having a guaranteed income stream in retirement via an annuity, including living longer.

If there are so many benefits of owning a guaranteed lifetime income annuity, why aren’t more Americans taking advantage of these programs? There are three major barriers that are preventing people from ever entering into the transaction.

The first issue that Americans have has to do with liquidity. In order to pull off the annuity deal, you have to give a large lump sum to an insurance company and you can’t undo the transaction. There is a psychological benefit to being able to access your money at a moment’s notice so the act of giving up liquidity is a major barrier for many people.

The second problem is the lack of inflation hedge. The typical single premium immediate annuity does not index for inflation and people are afraid the income provided may not be enough to cover their expenses in the future.

Some people approach the problem by increasing the lump sum at the beginning but that leads back to the first complaint of lack of liquidity.

The third problem is the “Mack Truck Factor”. If you go for a large annuity under the assumption that you will live for a long time but get flattened by a Mack truck a couple of years later, that asset will disappear from your balance sheet. However unlikely the proposition, the potential of making the worst investment ever and losing their kids’ inheritance is a scary scenario for many people.

Insurance companies are not blind to these three problems. They’ve created a fixed indexed annuity to try to address these issues and mitigate some of the risks involved.

To address liquidity, they allow you to withdraw 10% of that annuity per year. This isn’t full liquidity but basically functions the same way when you think about the 3% Rule.

To address inflation, the annuity is placed into a growth account that is linked to the upward movement of a stock market index. You’re not going to hit a homerun in this account but since the goal is to guarantee a stream of income until you die, this fits the bill.

The last issue is addressed by a death benefit. If you die up to two years after purchasing an annuity, whatever you don’t spend goes to the next generation including any growth on that money.

As great as all that sounds, the last issue is that 99% of fixed indexed annuities get implemented in the tax deferred bucket. There are two major problems with that approach.

When you have that annuity in your tax-deferred bucket, it can never be undone, which means you are exposing yourself to tax rate risk. If tax rates rise dramatically in the future you will have a hole in your income and will have to find a way to compensate.

The second issue is that taking money out of your tax-deferred bucket, even if it’s from an annuity, counts as provisional income and can lead to the risk of social security taxation.

The combination of these two things, tax rate risk and social security taxation, could force you to spend down your stock market portfolio 12 to 15 years faster than you otherwise would have.