Strategies for Leveraging Annuities in Portfolio Diversification
It isn’t necessary to use your entire savings balance to purchase an annuity in order to benefit.
Diversification is a strategy in which you allocate your assets according to your financial goals, typically with a mix of stocks and bonds, but annuities can also have a place in such a strategy. And because they offer guarantees, annuities can provide diversification as a hedge against the volatility of the stock market.
There are many types of annuities, but an income annuity that provides you with a guaranteed stream of income for life ensures a cash flow that won’t run out. Specifically in regard to retirement income, an annuity will continue to pay the same amount even when the market falls. This can help you avoid selling equity investments at a bad time in order to have the cash to pay for things like food and utilities.
Keep in mind that annuities are not investment products. Fixed annuities are insurance products that share characteristics with more conservative financial instruments, such as CDs. The tradeoff of owning an income annuity is that you receive a fixed and stable regular payment in exchange for the potential growth of investments.
That can be a fair trade for a portion of your portfolio, and including an annuity as part of your overall financial plan can give you some security as you allow your other investments to grow.
Establishing an Income Floor With a Fixed Annuity
A fixed annuity payment such as from a single premium immediate annuity (SPIA) can help you secure a certain level of minimum income, or floor, that you can rely on.
One strategy to consider is securing an income floor sufficient to cover all of your necessities such as housing, food and utility costs. When you have a secure floor, you can feel better about your other investments and may be better situated to weather volatility.
For example, suppose your necessary spending is $2,000 per month and your Social Security benefits cover $1,500 of that. An annuity that pays you $500 per month would be enough to know that you’ll be able to pay for it every month regardless of what happens with your investments.
Adding a Deferred Income Annuity
Another useful annuity for retirement income is the deferred income annuity (DIA).
This is similar to the SPIA, but the key difference is the payouts don’t begin immediately. Instead, you can delay the payments until some point in the future.
A good use of a DIA is to provide a “backstop” on your retirement income plan. For example, suppose your health and family history suggest you’ll live to be 80, but that it’s unlikely you’ll live past that. Purchasing a DIA with payments beginning at age 80 allows you to spend more freely and enjoy your life now without worrying about what will happen if you live longer.
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Strategies for Minimizing Taxes Using Annuities
Income annuities can also factor into your tax plan. Because taxes have a significant impact on your retirement, tax planning should be a major part of your plan. Tax-efficient planning can lower your retirement taxes, make your money last longer and allow you to spend more on the things you need and enjoy.
You can purchase an annuity with money inside a tax-sheltered plan like a 401(k) or IRA, or with cash in a taxable account.
It’s important to remember that:
- Annuities purchased within a retirement plan are called qualified annuities, and your payment is taxed like any other withdrawal from that plan.
- Annuities that are purchased with money outside a tax-advantaged plan are called nonqualified annuities and are taxed differently.
Nonqualified annuity payments are considered a combination of gain and a return of your premium. You are only taxed on the gain. To figure out the portion that you won’t have to pay taxes on, you use a measure called the exclusion ratio.
Navigating RMD Requirements With an Annuity
If you have a traditional IRA or 401(k), the IRS requires you to make withdrawals of certain minimum amounts when you turn 73 and every year after that. Those withdrawals are called required minimum distributions, or RMDs.
RMDs can have tax and savings implications that some retirees want to avoid, especially if they don’t need to spend the money when withdrawals are required. You can use annuities to mitigate those concerns.
For example, you can use the money you’re required to withdraw to purchase a flexible premium fixed annuity. With a flexible premium annuity, every premium payment adds to the annuity’s value, and the annuity will continue to grow tax-deferred.
This is not a way to avoid the immediate tax implications of the RMD, but it will help you make the money last longer.
Incorporating Qualified Longevity Annuity Contracts (QLACs)
A qualified longevity annuity contract (QLAC) is a deferred annuity purchased inside a qualified retirement account. Under the law, a QLAC can account for 25% of the retirement account’s total balance up to $125,000.
The value of the annuity is exempt from required minimum distributions, which means an annuity strategy that includes a QLAC can reduce your RMDs by as much as 25%.
You are not required to take distributions from a QLAC until the age of 85. This allows the money to accumulate over a longer period of time, which leads to greater income-benefit payments from the annuity.
Strategies for Maximizing Your Annuity Income Benefits
Annuities are one of the most effective ways to generate guaranteed income for life. There are several ways you can maximize your annuity income and get the most protection possible. One broad strategy you should keep in mind with buying annuities is to keep things simple. The more riders you buy and the more complex your annuity is, the more expensive it will be and the lower your payments will be.
You can employ many other annuity strategies to help maximize your income.
Delaying To Maximize Payment Amount
Annuity payments are based in part on how long the insurance company expects to pay you. The longer that period is, the lower your payments will be. You can increase your payment by waiting to begin receiving your payments.
For example, if you start taking payouts as soon as you’re able, at age 59 ½, the monthly payments will be much lower than they would be if you wait until age 75.
The catch here is that you don’t know how long you’re going to live. If you wait too long, you may not get any benefit at all from your annuity. But if you’re relatively healthy and come from a family where people tend to live longer, you may want to delay receiving annuity payments as long as you’re comfortable waiting. This strategy is similar to deciding when to claim Social Security benefits.
Using Multiple Annuities as a Ladder
Annuity laddering strategies involve purchasing multiple annuities to make the most of changing market conditions.
The goal of annuity laddering is to maximize your return by dividing your principal among a variety of annuities at different times. This allows you to take advantage of changing interest rates without missing opportunities under the current market conditions.
For example, if you have $400,000 to spend on annuities, you can buy an annuity for $100,000 in each of four consecutive years. Or you can buy several annuities with different surrender periods. As each surrender period ends, you evaluate whether to keep your money in the same annuity or withdraw it and buy a new one with better, more current features.
You can also buy multiple deferred annuities that start paying out at different times, allowing more growth for the contracts with longer accumulation phases.
Charitable Gift Annuity Income Strategy
Charitable gift annuities offer donors and charities a win-win situation. They allow donors to transfer assets to a charitable organization in return for regular payments for the donor’s lifetime.
According to the American Council on Gift Annuities, thousands of organizations, from the American Heart Association to the Youth for Christ Foundation, offer charitable annuities as part of their fundraising efforts.
Lock In Fixed Annuity Rates as High as 6.4%
Frequently Asked Questions About Annuity Strategies
QLACs are a type of annuity that can reduce required minimum distributions (RMDs) by 25% and delay distributions until age 85, allowing for more significant growth and strategic retirement planning.
Annuity laddering involves purchasing multiple annuities at different times to create a staggered income stream. This strategy maximizes returns in changing market conditions while providing consistent income.
Charitable gift annuities are agreements where a donor gives assets to a charity in exchange for regular payments. This strategy supports charitable causes and offers financial benefits, including potential tax deductions.
Annuities provide a fixed or variable income stream, acting as a stable investment that can offset market fluctuations. By incorporating annuities into a diverse portfolio, you can create a more resilient financial strategy.