Survey after survey has shown that longevity risk, the risk of running out of money prior to death, is far and away the top concern for a generation of baby boomers. To address this, financial advisers have increasingly turned to annuities with lifetime income riders to help mitigate that risk. After a deferral period, the retiree can elect to receive a stream of income that’s guaranteed to last as long as they do.
Creating a guaranteed floor of income in retirement has been shown to confer an array of psychological and health benefits and is gaining wider currency among a generation of retirees. A recent survey by The Wall Street Journal showed that retirees with guaranteed income are generally happier and Stephen Dubner of “Freakonomics” fame has even made the case that it could extend your life.
But there’s a rarely discussed dark side of these annuity arrangements that should be brought to the fore, particularly given our country’s gloomy fiscal outlook and mounting debt load. Over 95% of the time these annuity arrangements are implemented within pretax vehicles such as IRAs. When the retiree elects a lifetime income therefore, that lifetime income shows up as taxable income on their tax return.
This poses two fairly significant problems.
First, because this guaranteed lifetime stream of income is taxable, it exposes the retiree to the impact of tax rate risk. There is growing consensus that tax rates even 10 years from now will be dramatically higher than they are today. Former comptroller general of the federal government David Walker has predicted that tax rates would have to double to pay for unfunded obligations such as Social Security, Medicare and Medicaid along with interest on the national debt.
More recently Ray Dalio, Larry Swedroe, Leon Cooperman, Larry Kotlikoff, and Ed Slott have said that tax rates have to rise dramatically soon, or we go broke as a nation. So, while guaranteed lifetime income might solve your problem at current tax rates, your after-tax income diminishes as tax rates creep higher over time. The resultant hole in your lifetime income would somehow have to be plugged. Retirees would likely be forced to spend down their other stock market assets to compensate. This could force them to exhaust their liquid savings far sooner than they thought possible.
The second problem is Social Security taxation. Any distributions from tax-deferred retirement accounts, including guaranteed lifetime income from annuities, count as provisional income. That’s the income the IRS tracks to determine whether they’re going to tax your Social Security. By drawing lifetime income out of annuity situated in your IRA, you could inadvertently breach the Provisional Income thresholds that cause Social Security taxation. It isn’t unusual for retirees who rely on their IRAs in retirement to pay anywhere from $3,000 to $6,000 in Social Security taxation. And how do they plug that hole in their Social Security? You guessed it, by spending down their stock market portfolio to compensate.
Here’s the bottom line: the combined cost of rising taxes and Social Security taxation could force you to spend down your retirement portfolio 7 to 10 years faster than you ever thought possible.
Historically annuity companies have addressed these two major issues by giving you the ability to convert your IRA annuity to a Roth IRA. But that option has always come with a major caveat. You had to convert your entire IRA annuity all in one year. Given a large enough annuity, that could easily push you into the highest marginal tax bracket. So much for trying to shield yourself from higher taxes. In an effort to avoid a doubling of taxes over time, you doubled your taxes in the short term!
More recently, a few insurance companies have pioneered what I call a Piecemeal Internal Roth Conversion (PIRC). This allows you to convert your IRA annuity to a Roth IRA in smaller amounts and over a time frame that can help stretch out your tax obligation, keeping you in much lower brackets along the way. Once the conversion is complete, you can then draw your guaranteed lifetime income from your Roth IRA. This shields you from the impact of rising tax rates and can put you in a position to receive your Social Security 100% tax-free.
Because of this, you won’t be forced to spend down all of your other assets to compensate, dramatically increasing the likelihood that your stock market portfolio will last as long as you do.