When Could An Annuity Make Sense In a Financial Plan?

Welcome to Ewa’s finlit podcast. Ewa is a fee only RAA based out of Pittsburgh, Pennsylvania. We hope all listeners of this podcast will benefit as we deep dive into complex financial topics that we will make simplified for you. And we hope that this really serves as a catalyst so that you can make the best financial planning decisions for your family and also save time.
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Speaker 2
00:29
Today’s episode, Ben and I are going to take a dive into annuity, into what annuities are when they make sense for a financial plan. We did one podcast earlier on the good pros and cons of annuities, and we’re going to focus more on use cases and when we see time in place for them to be implemented in a financial plan. So, Ben, why don’t you give us just refresh everybody, general overview. What is an annuity?
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Speaker 3
00:54
Yeah, I think of annuity as kind of the opposite of life insurance. I think that’s the simplest way that I can explain. A lot of annuities are complicated. There’s a lot of different types of annuities on the market that you could have in your financial plan. But just from a super high level overview, think of life insurance as you pay the life insurance company a little bit, a little bit over time, and then when you die, you get a big check. Think of the annuity as the exact opposite. You give the insurance company a big check, and then over time, you get a little bit, a little bit back in the form of either a monthly payment or annual payment, depending on the type of annuity.
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Speaker 3
01:30
So life insurance, it protects you if you die too quickly. So that is protection if you die. Annuity is the exact opposite. It protects you if you live too long. In theory, it’s going to guarantee you some sort of income stream for the rest of your life. And so that’s kind of how that would work in practice. There’s a lot of different types. Again, like you mentioned, you did a podcast with Matt more, so talking about some of the different types, the positives, the negatives, we’re going to focus today’s podcast primarily on a couple cases of annuity, when it might make sense in your financial pland why that works.
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Speaker 2
02:05
Awesome. So basically, there’s two different main, there’s a lot of different types of annuities, but break them down into two categories. Fixed annuity, variable annuity. So what’s a fixed annuity?
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Speaker 3
02:15
Fixed annuity, putting a lump sum in, and then you get basically a fixed percentage back from the insurance company year over year, depending on what that stated rate would be. A variable annuity is a little bit more market based. So it’s maybe invested in like a sub account that the insurance company would be managing that would more so track a return more so related to the stock market, whereas a fixed annuity would be a fixed guaranteed rate.
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Speaker 2
02:47
So different types of fixed annuity. We’ll just hit on these briefly. Spia. SPIA, what’s that stand for?
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Speaker 3
02:55
Single premium immediate annuity. So basically, you put a lump sum into the insurance company and then right away start getting payments, whereas a deferred immediate annuity, a different income annuity, excuse me, put money in, and then you set a date in the future, maybe five years, ten years down the road, you say, hey, this is when I’m going to start receiving payments. And so in that 510 year window, whatever the number is, that money starts accruing interest based on whatever the fixed rate that you locked in at the time of purchase, and then you start getting money back at whatever rate, at whatever time that you have set.
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Speaker 2
03:31
So let’s use an example. Let’s say you’re 65 years old, you’re about to retire, and you take $300,000, you put it into an immediate annuity, and it starts paying you out some sort of income streams. There’s no deferral period, so it’s not going to grow. You put it in immediately, starts paying. A couple of variables, decisions that you’d have to make. Number one, are you going to add like a period? Certain. So a lot of times it’d be a 20 year guaranteed period? Certain. So if you’re living for 20 years beyond 20 years is going to pay out. If you die before 20 years, somebody’s getting that benefit for guarantee of 20 years. If you die at year ten, whoever the beneficiary is gets it for the full 20 years.
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Speaker 3
04:15
So that’s important. So if you put money in the first day and you die a day later, insurance company guarantees that your spouse or whoever you put as the beneficiary receives annuity payments for that full 20 years.
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Speaker 2
04:27
If you have a 20 year period, sir, not all annuities have that. And then there’s different types of, you can take it for single life. So it’s just one person, a joint life. There’s a bunch of different ways to claim these, but you could get a higher payout just on your life. Maybe there’s a period certain you could do a joint life where you’re taking a lower payout but it’s going to pay out. If one spouse dies, the other spouse gets it their whole lifetime. Those would probably be the two main options. But the deferred income annuity, let’s say you put the 300,000 in and you’re going to claim it and you’re going to start taking payouts in five years. So that five year period of deferral, again, this is not market based. It’s going to be some sort of interest rate growth.
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Speaker 2
05:13
And a lot of times if, depending on the annuity company, they’re going to pay out some sort of interest rate based on how the company performs, similar to like a life insurance contract. And that could be a reasonable alternative for a bond investment. So there’s high interest rates, high interest rate environment, could be a more favorable interest rate than a fixed income instrument. But super, there’s a lot of variables, what interest rates are, what’s going on with the economy, client situation, etcetera. But anything else on a, just general overview of how fixed annuity works.
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Speaker 3
05:47
Yeah, and we’ll get into this a little bit more, but when do you think this makes sense for someone’s plan or for someone’s overall financial plan? What age should someone be thinking about a fixed annuity? What net worth? What characteristics do they want from this?
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Speaker 2
06:02
Yeah, very few. I don’t think I’ve ever actually recommended and implemented one. I would say one use case would be if we do have a really conservative client that just doesn’t want to, I guess it’s more for peace of mind. So if it stresses them out to see market fluctuations, one strategy is we would always want, we could want 50% at least of their income needs coming from something guaranteed. So let’s just say somebody’s spending 200,000 a year, it’s their basic needs for retirement, Social Security. Two spouses that say it’s paying them 75 a year, they don’t have a pension.
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Speaker 2
06:46
And so maybe we say, okay, let’s get some sort of annuity product that’s going to pay 25,000 a year to bridge the gap and have them have 100,000 of guaranteed income, which would be 50% of their $200,000 thousand need, could go above that. But a lot of times, all times, we could just make up the difference from investment returns or some sort of distribution strategy. But I would say that’s really the only real use case. Maybe if, like, there was a weird interest rate environment where you could, someone’s getting ready to retire and you can get a very high interest rate on annuity, locking in a higher rate, knowing interest rates are going to drop. Again. I’ve never actually recommended or implemented that, because a lot of times we can just replicate the exact same thing with.
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Speaker 3
07:28
Investment returns and generally lower costs, too, from what annuity would, a fixed annuity would offer. Right?
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Speaker 2
07:34
Yeah. Well, let’s dive into what’s a qlac?
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Speaker 3
07:39
So QLAC, that stands for qualified longevity annuity contract. And this is something that has been adjusted with the Secure Act 2.0 that was just passed, I believe, two years ago now. So let’s just break down QLAC as an acronym, what that means. So Q qualified. That means that the annuity has met the requirements set by the government for preferential tax treatment. So tax deferral on any sort of QLAC that is qualified longevity. Again, this goes back to the annuity portion. Make sure that you’re not outliving your money. So essentially, what a QLAc is it is annuity contract that is purchased with money that is sitting in a retirement account. So if you have an old 401K that maybe you rolled into a traditional IRA, you’re able to put up to $200,000 into a QLAC.
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Speaker 3
08:33
And why you would do this, or why this might make sense is that any money that goes into a QLAC, you defer any required minimum distributions that you have to start taking at age 73 up until your age 85. So you have that twelve year window where you’re deferring RMD’s, you’re pushing those back, and then once you hit 85, any of the money that’s sitting in the QLAC becomes a single life annuity. So, like we mentioned, that becomes a fixed payment that you start receiving from 85 throughout the rest of your life cannot be purchased with assets from a Roth IRA or an inherited IRA. But if you have, like, an old pre tax balance and you’re concerned about what your RMD requirement would be, this is something that could make sense. We’ll get into a real life example soon.
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Speaker 3
09:22
But qualified, it’s tax deferred longevity. You’re putting payments off until age 85, and it’s annuity contract. So you’re guaranteeing a stream of income, regular payments, really, for the rest of your life.
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Speaker 2
09:34
Basically, deferring RMD’s on a portion of your IRA balance.
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Speaker 3
09:38
Exactly. Case study in this, let’s say you have a 73 year old that is now subject to RMD’s with their IRA balance. Let’s say they have $400,000 in their IRA. Their RMD from that $400,000 balance will be somewhere around $15,000 that they have to take out. So if they decide, hey, I’m going to put 200,000 of my $400,000 IRA into a QLAC, then their RMD amount that they’d be subject to when they’re 73 is now 7500 instead of the 15,000. So they basically cut their RMD in half, lower their income tax on the RMB that they have to take, and then plus they defer tax on the other 200,000 that’s now in the QLAc until. Until they’re age 85. So, again, does this make sense?
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Speaker 3
10:29
Totally case by case basis, I would say the big downside of this, or maybe why we wouldn’t recommend doing this, is that a lot of times the same returns or more can be gained in a traditional portfolio, again, without the expenses of the QLAC or without the expenses of the annuity. But this is a good way for people that, it’s a good way almost to almost force people in a good way to leave money in their iras, because people generally feel good about spending their RMD’s and not taking distributions from their IRA.
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Speaker 2
10:58
Yeah. Again, I’ve never recommended, implemented this, but it’s out there so important to be educated on it. Could be used to defer some RMD’s. But let’s get into variable annuities. Yeah. Ben, why don’t you just give us an overview of what a variable annuity is?
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Speaker 3
11:14
Yeah, can we just stop for a second?
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Speaker 2
11:17
Yeah.
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Speaker 3
11:19
I mean, variable news never makes sense. Raised.
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Speaker 2
11:22
Yeah.
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Speaker 3
11:23
So, like, I just had this, like, in case we wanted to go into it.
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Speaker 2
11:25
Well, I just gave an overview of it.
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Speaker 3
11:26
Yeah. Okay, cool. Okay.
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Speaker 2
11:33
What is a variable annuity?
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Speaker 3
11:34
Yeah, so a variable annuity. A lot of the same characteristics of a fixed annuity that we talked about, but instead of a guaranteed rate that the insurance company is going to guarantee over the life of the annuity, a variable annuity means that their actual investments are in a sub account. So it’s more so tied to equities than a fixed rate. So your actual payment is not guaranteed. It could go up or down depending on the performance of the sub accounts. Again, there’s a lot of fees. A lot of expenses. This is something that we’re not generally recommending for our clients. Yeah. I don’t know. Like what? I don’t even know if we need to talk about this, honestly.
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Speaker 2
12:20
Yeah. Basically, it’s putting money into annuity contract that’s growing with the market instead of the fixed amount, and then you have the option to turn it on as an income stream down the road. These are, in my opinion, grossly oversold, made out to be way better than they are. They’re very expensive. You’re usually, you’re invested in funds that are proprietary to the insurance company and the annuity contract. So it’s not like you’re just in a standard, like, ETF index fund. You’ll be in like, a insurance companies like variable annuity fund. So a lot of times expensive. There’s just not very many use cases for these. A lot of times when we come across a variable annuity, we’re trying to figure out how do we efficiently get out of this thing without, you know, staying in for a million reasons.
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Speaker 2
13:09
But, yeah, I would say zero use case for variable annuity. Maybe actually one. I’ll give one. We have done this. If there is a, if somebody wants to surrender a life insurance contract and the cash value is lower than the basis, you do a 1035 into a variable annuity, invest it in the market, and then once the amount reaches the basis, then you surrender it. Because if you surrender it immediately and put it into investment account, the difference between whatever the basis of the life insurance is taxable versus if it goes into the variable annuity, you can save on taxes up to that basis. Gotcha. So that’s really the only use case.
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Speaker 3
13:55
I’ve seen, and that’s a tax free exchange, the 1035. So that’s a tax free, penalty free exchange from the life insurance contract into the variable annuity, getting the basis back up to neutral, and you’re avoiding tax on whatever that growth would be, as opposed to an investment account, you could be subject to capital gains. So, yeah, that case could make sense. But I would say, generally speaking, variable annuities, index annuities are not something that are part of our recommended financial plans.
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Speaker 2
14:21
Yeah, and a couple other use cases. So some annuities, if they’re a Medicaid qualified annuity, they could help with Medicaid spend down protection. So basically, if you took money, put it into annuity, and then needed to go into an assisted living facility, they can’t come take the principle of the annuity. As long as you’re taking out the required amount every year that could be protected from Medicaid. If you’re in a qualified annuity, that is Medicaid qualified. So that one use case, and I thought this was interesting, there was a Wharton study that basically said it looked at using annuities for income stream in retirement and said that higher paid and higher educated retirees, it’s much easier for them to spend down their retirement assets, and lower paid, less educated retirees have a harder time spending down retirement assets.
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Speaker 2
15:16
So what that means for annuities is like, could be a situation. Again, probably wouldn’t recommend this, but could be if somebody, if it gives them peace of mind to have that guaranteed income stream because they have a hard time spending down their retirement assets, maybe you could implement annuity. But most people, if they’re well educated on the retirement situation, they’ll understand that there’s efficient ways to spend down your retirement assets.
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Speaker 3
15:42
Gotcha. Yeah, makes complete sense, I would say. If you’re thinking about annuity, I would consult with a financial or tax professional to see if it makes sense in your financial plan.
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Speaker 2
15:57
Yeah, totally agree. If you have annuity you want analyzed, feel free to reach out. Or if you’re considering it. But most cases, you know, not a practical, practical tool for most financial plans.
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Speaker 3
16:11
Yeah. If you have any questions about any annuity that’s in your financial plan or your financial plan in general, feel free to reach out to a trusted tax or financial advisor and we’ll catch you on the next episode.
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Speaker 1
16:21
Thanks for tuning in to our podcast. Hopefully you found this helpful. Really hope this is as beneficial and impactful to as many people across the nation as possible. So hit the follow button, make sure to rate the podcast and please share with any friends or family members that would also find this beneficial. Thank you very much.
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