INTRODUCTION
As retirement age draws near, every individual is faced with the dilemma:
How can one make a rational decision on the most efficient means of distribution of qualified money? As revealed by Figure 14.2, the major sources of retirement income consist of income from: personal investment, corporate-sponsored qualified plans and other tax-advantaged plans (SEP IRAs, Simple IRAs, 403b, or 457), self-employed plans, individual IRAs and Social Security. Of these, personal investment income was discussed in detail in Chapters 8, 9, and 10. The rest of the choices will be discussed in this section.
Since there is little difference between corporate-sponsored qualified plans and self-employed plans on retirement income distribution, no distinction will be made between them.
Personal investment
Corporate- sponsored qualified
plans
Self-employed
plans IRA Social
security
Regular
withdrawal Systematic withdrawal
Late retirement Early
retirement Retirement
IRA rollover Lump-sum
distribution Annuity
Immediate Deferred
Fixed Variable
Figure 14.2 Major Sources of Retirement Income Source: Author’s own work.
Note: Some plans are available only in the US. These are included simply to emphasize that retirement may depend on many sources.
Company-sponsored Qualified Plan and Self-employed Plan There are three principal ways in which an individual can withdraw retirement money: an annuity, lump sum distribution, or a rollover. At stake is the bulk of the retirement wealth. Furthermore, since the choices open to the retiree are almost always irrevocable, and the outcomes of the distribution decisions are vastly different, be careful in making this decision. We will now discuss each of the three key distribution choices available.
Annuity
The Annuity Principle. Life insurance enables an individual to purchase a contract providing a definite sum of money at the time of death. Such contracts are pos- sible because the mortality of a large group of individuals can be predicted with reasonable accuracy.
A different problem, however, faces the individual who has accumulated a sum of money and wants to determine how much can be safely spent each year during a lifetime so he or she will not run out of money. If the money is spent too rapidly, someday the funds will be exhausted—possibly with several years of life remaining. In contrast, if the funds are disbursed too slowly, at the time of death a portion of the funds will be left, money that could have been used to maintain a higher standard of living.
Confronted with this problem, no one person can be certain as to what sum can be safely spent each month. However, this uncertainty does not apply to a large group. Through the use of mortality tables, in return for the payment of a lump sum or a series of payments, insurance companies can make guaranteed life- income payments to various individuals, because the mortality rates of each group can be predicted with reasonable accuracy. Put differently, the greater total sums paid to those who live to unusually advanced ages can be balanced by the smaller payments made to those who die relatively early. Such payments are called annuities.
The word annuity implies payments made by an insurance company at fixed intervals, such as monthly, quarterly, or yearly. When a life insurance policy is pur- chased, payments are made to the insurance company during the policyholder’s lifetime, and the company pays a stipulated amount when the policyholder dies.
With an annuity, an individual pays a given sum to the insurance company, and in return receives an income according to various options (discussed later). An annuity contract, therefore, is essentially the reverse of a life insurance policy, although it is not an insurance policy.
Under the classic, or original, type of annuity, the income ceases with the death of the annuitant, and the insurance company is under no further obligation.
Fortunately, many important variations of the original type are available in the marketplace today, as revealed in Figure 14.3. This figure reveals that annuity contracts vary according to how the payment for the annuity is made, how the proceeds are distributed, how earnings accrue, and when the benefits are received by the annuitant or beneficiary. Of these features, disposition of pro- ceeds is of special interest for the individual planning to retire.
It might be interesting to think of an annuity as a liquidating retirement pay- ment plan, illustrated in Figure 14.4. Assume Betty Jones retires at age 65 with an after-tax lump sum distribution of $100,000. She purchases an annuity. It guarantees an income for 20 years (20-year fixed period). During this 20-year period, in addition to receiving her principal of $100,000, Betty will receive an additional $10,185 representing the return on the principal in the form of inter- est. Put differently, the monthly income received by Betty will consist of interest and a portion of the original investment. Consequently, at the end of the 20-year period, the entire investment will have been liquidated and the company will owe nothing to Betty Jones.
Disposition of Proceeds. Various options available under an annuity plan, which were briefly discussed in Chapter 4, are presented in Figure 14.5. The figure reveals that the annuity can be either fixed or variable. The former refers to an annuity contract which promises a fixed return during the life of the contract.
It is, therefore, not dependent on the results of the vehicle in which the money is invested. However, typically the payment is fixed on an annual basis (with a minimum guarantee of two to four percent) so the fixed payment does not vary from year to year. In contrast, a variable annuity is a form of contract that
Annuity distribution
Straight life
annuity Joint and last survivor life
annuities
Life annuities with guaranteed
payments of refund features Fixed
period Fixed amount Installment
payments over Cash
surrender
Figure 14.3 Forms of Annuities Source: Author’s own work.
Liquidating funds
Value of investments
$100,000
t = 0
Start of retirement income Years t = 20
End of income
Figure 14.4 Liquidating Retirement Payout Plan Source: Author’s own work.
Payout
Fixed annuity Variable annuity
Life period certain Joint and
survivor period certain Joint and
survivor Life only
No refund at death
100%
to survivor
15 yrs.
certain
20 yrs.
certain 10 yrs.
certain 662/3%
to survivor
50% to survivor
5 yrs.
certain
Figure 14.5 Disposition of Annuity Proceeds Source: Author’s own work.
is invested in one or several mutual fund portfolios. In this case, payments can vary in size, depending on the rate of return on the portfolios selected. In both cases, the options available to the annuitant are identical, although gen- erally the amount of the annuity payments will vary—sometimes greatly—
between the two methods of payment. We will now discuss the key choices available to an annuitant.
• Life only pays for the annuitant’s lifetime and pays nothing to the surviv- ing spouse or other heirs.
• Joint and survivor pays a reduced amount to the annuitant during his or her lifetime and then continues 100 percent, 66.67 percent, or 50 percent of the original payment over the remaining lifetime of the surviving joint annui- tant. Payments stop after the death of the annuitant and the joint annuitant, and the company owes nothing to the beneficiaries.
• Joint and survivor period certain promises that payments will continue for at least the minimum (for instance, 10, 15, or 20 years) guaranteed period even if the annuitant (or both annuitants) dies during this period. If the annuitant survives longer than the specified period, the annuity contin- ues to pay the same amount until death. Joint plus survivor period certain is a variant of life period certain, in that payments are made at least for a specified period or until the death of both parties.
• Life period certain pays the annuitant for as long as the annuitant lives or a minimum number of payments, whichever is longer.
Tax Treatment of Annuity Payments
Each annuity payment represents a combination of the return of principal and interest on the principal. If the principal has already been taxed, it is not taxed again when the payment is received. In the event that after-tax contributions had been made to the qualified plan, the following table illustrates that the excludible portion of each payment is calculated as a recovery of the after-tax portion by dividing the cost basis by the number of anticipated payments.
Age on Annuity Starting Date Number of Anticipated Payments
Not more than 55 360
More than 55 but not more than 60 310
More than 60 but not more than 65 260
More than 65 but not more than 70 210
More than 70 160
Variable Annuity. Under the variable form of annuity payments, the monthly payments are made from a variable account that fluctuates based on invest- ment results. So the expected return cannot be accurately determined in advance. Therefore, Treasury regulations make the assumption that the expected return is equal to the investment in the contract. The excludable por- tion of each payment is calculated by dividing the investment in the contract by the anticipated number of months times the monthly payout. Assume the monthly payout of a five-year variable annuity is $990.02 and the initial lump sum payment is $50,000. Here the $50,000 investment would be divided by the five years of payout ($50,000/($990.02 × 12 × 5) = 84.17 percent) and 84.2 percent of each monthly payment of $990.02 or $833.30, would be excluded from gross income. Essentially, the tax treatment is the same for both fixed and variable annuities.
The Best Choice. Clearly, the best choice of an annuity option depends on the objective of the annuitant and the total amount of retirement income expected from other sources. Individuals who wish to receive a guaranteed life income to supplement Social Security and other investment income should choose either the life only or joint and survivor option, possibly with a minimum period of guarantee of 10 or 15 years. However, those who have other sources of income and wish to use up the lump sum in a relatively short period may choose a guaranteed income for, say, five or 10 years. Finally, if the retiree can assume the market risk, a variable annuity should be considered. That is because there is a potential for growth.
Lump Sum Distribution
An Overview. One of the valuable options available to most retirees is to receive the nest egg in one lump sum instead of as an annuity. If a decision is made to receive the lump sum, then the retiree comes to the second crossroad: whether to pay the tax on the lump sum now or postpone the tax by rolling over the money into an IRA. If it is the latter, then the money must be directly transferred or rolled over into an IRA within 60 days. If the first choice is preferred, however, the employee must resort to a sophisticated tax planning strategy, as now described.
IRA Rollover
The third distribution option is to directly transfer the funds, or roll over the funds into an IRA within 60 days of the lump sum distribution. With a rollover
IRA the retiree avoids paying current taxes on the distribution. Instead, taxes are paid when money is withdrawn. The advantage in choosing this option is no penalties are imposed for the rollover. The individual can choose how the money is invested through a self-directed IRA account. Most important, the entire distribution continues to grow tax- deferred over the life of the IRA. A disadvantage of this option is that all IRA conditions are imposed on such rollovers.