Include Laddered Annuities In RMD Tax Rules, Researcher Recommends

A researcher at George Mason University has come up with what he believes is an effective strategy to guarantee lifetime retirement income.

The approach entails combining laddered immediate annuities with systematic withdrawals from retirement accounts, plus a tax rule change that provides an incentive to purchase the annuities.

If the proposal gets legs, it could spur more use of immediate annuities with qualified retirement assets and thus greater use of annuitization to ensure lifetime income, Mark J. Warshawsky told InsuranceNewsNet. Warshawsky is senior research fellow at the university’s Mercatus Center and is the author of a new study on the strategy.

The approach also could unleash more innovation in retirement income strategies, Warshawsky predicted.

A twist on combo strategies

Numerous combo retirement income strategies already exist in the planning community. They typically rely on blends of two or more asset categories such as pension income, annuity income, qualified plan withdrawals, managed money earnings, Social Security maximization and even part-time income from work.

But Warshawsky’s proposal has a twist: In addition to combining annuitization with systematic withdrawals, he suggests that the Department of the Treasury (DOT) broaden a current rule to provide a tax incentive that would spark greater use of this type of strategy.

This rule is the DOT regulation that took effect in July 2014, creating qualifying longevity annuity contracts (QLACs) for use inside of individual retirement accounts and defined contribution plans. The stated purpose is to promote partial annuitization, Treasury officials said.

These specialized annuity policies are deeply deferred income annuities, also called longevity annuities. People who buy these contracts can defer taking required minimum distributions (RMDs) from their annuity up to age 85. The tax incentive is that people who buy these annuities can defer paying taxes on the annuity-related RMDs until the payouts (distributions) actually occur.

Warshawsky said a similar tax approach applied to laddered annuities in a combination strategy would further support the government’s partial annuitization objectives and guaranteed retirement income goals. His reasoning goes this way:

• Retirees who rely solely on a strategy of drawing down assets for income through systematic withdrawals run the risk of outliving their savings.
• Life annuities mitigate this risk by offering guaranteed income for life. However, converting the entire retirement portfolio into life annuities at retirement fails to provide end-of-life assets for bequests, is a poor hedge against inflation and does not provide sufficient liquidity in the case of emergency needs, he said.
• Therefore, many financial planning experts favor partial annuitization strategies. However, while the 2014 tax ruling does provide an incentive to annuitize some of a person’s qualified savings to purchase longevity annuities, it does not provide an incentive to purchase laddered immediate annuities with qualified money. It is unclear why the current strategy “merits special treatment compared with other partial annuitization schemes, such as laddered purchases of immediate life annuities, which are more comprehensive and efficient,” Warshawsky wrote in the study.
• If the current tax rule were broadened to include immediate annuities purchased with qualified funds, this would help promote greater use of annuitization in retirement income plans, he said, noting this is in keeping with government objectives.

His suggestion

Combining asset withdrawals and laddered purchases of immediate life annuities provides the best balance of lifetime income and flexibility, Warshawsky told InsuranceNewsNet.

To illustrate, he pointed to an individual who retires at age 62 with $100,000 in qualified money saved for retirement. If the person lives to age 102 and has been taking $4,000 a year, inflation indexed, as withdrawals, the individual has a 35 percent chance of running out of money, Warshawsky said. “By comparison, the combination strategy would produce an average of $4,500 in yearly income, and the person would still have almost $76,000 left for bequests at age 102.”

However, current tax rules do not provide consumers with an incentive to purchase those annuities in such an income plan, Warshawsky said. In addition, because longevity annuities typically have a higher expense load than immediate life annuities, the longevity-only approach may introduce unwanted costs.

His suggestion is for the government to make “a broad and simple change” in the RMD tax regulations.

Specifically, he said, “the minimum distribution requirements that govern tax-qualified retirement accounts for older retirees should be reformed to encourage the use of these partial annuitization combination strategies.”

Current rules “penalize annuitization by not completely counting annuity payouts toward RMD requirements,” he said. The effect is that retirees with a partially annuitized portfolio will be required to pay taxes significantly earlier than retirees who do not purchase annuities with qualified money, he said.

The reform would “incentivize laddered purchases of annuities at whatever rate is deemed optimal for individual retirees,” he predicted.

It would also “dramatically simplify an unnecessarily complicated portion of the tax code” and it would require only “a change in regulations and not a change in law.”

Even without the tax law change, combination strategies like this are “the way to go in many situations,” Warshawsky contended. “It’s up to the advisor to customize the recommendation to meet the client’s needs and goals.”

InsuranceNewsNet Editor-at-Large Linda Koco, MBA, specializes in life insurance, annuities and income planning. Linda can be reached at [email protected].

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Linda Koco, MBA, is a contributing editor to InsuranceNewsNet, specializing in life insurance, annuities and income planning. Linda can be reached at [email protected].