Swap lump sum for lifetime income

Your Money

July 24, 2005|By Humberto Cruz

Q. Your article about variable annuities with a lifetime income guarantee was interesting. Could you explain in more detail the differences between this benefit and annuitization?

A. I wrote about a relatively new lifetime income benefit rider offered by several insurance companies that issue variable annuities. With this optional benefit, which comes at an extra cost, the annuity purchaser can choose to receive a minimum lifetime income regardless of how the annuity investments perform and without having to "annuitize," or give up access to principal.

Annuitization consists of exchanging a lump sum premium - or in the case of an existing variable annuity, the account value - into a stream of lifetime income.

Based on a recent quote from a top-rated insurance company, a 65-year-old man putting in a $100,000 lump sum would receive payments of $643.52 a month for life, and a 65-year-old woman would receive $559.50. The lower payout for women reflects the fact that on average they live longer than men.

Payments can be set up so they continue to a beneficiary after the original recipient dies, and/or for a minimum number of years. The more such conditions are attached, the lower the payments will be.

And the basic premise remains: With annuitization, there is no longer a principal or account value to access, only a promise of future payments guaranteed by the insurance company.

With the new variable annuity benefit, the lifetime payments are deducted from the actual account value. The guarantee by the insurance company is that, even if the account is depleted by bad investment results, the investor will continue to receive the lifetime income.

Also, as long as money is left in the account, it can be accessed by the investor or passed on to heirs. Withdrawals in excess of the guaranteed amount, however, may reduce or end the lifetime income guarantee.

If retaining access to your principal and being able to pass it on is important to you, the newer benefit may be appealing. But if your main objective is higher after-tax income, annuitization makes more sense, at least at first.

This discussion applies to "nonqualified" annuities - those not part of IRAs or other qualified retirement plans:

With annuitization, part of each payment is considered a return of principal until the lump-sum premium is paid back. The rest of the payment is taxable. In the example of the 65-year-old man, nearly 65 percent of each payment would be tax-free for the first 20 years. For the woman, 69.5 percent would be tax-free.

By comparison, with the lifetime income benefit rider, all payments are considered taxable earnings as long as the money that remains in the account is as much as or more than your tax basis or "investment in the contract" (the money you put in minus what you take out). If the account value dips below the tax basis, withdrawals represent a return of principal and are not taxed.

But because the account value can fluctuate, it is impossible to estimate the tax liability ahead of time. My recommendation: Don't buy this product without competent tax advice.

In the case of qualified annuities (such as those used in IRAs), the taxation of withdrawals follows the rules for those retirement plans, which are too complex to cover here. But I should add this caution: The guaranteed income benefit may be affected by minimum required distributions from traditional IRAs after age 70 1/2 .

Another difference: With annuitization, the size of each payment you receive depends on how big a lump sum you invest and the prevailing interest rates, as well as your life expectancy at the time of annuitization (the older you are, the bigger the payments). With the income benefit rider, the guaranteed annual income is typically 5 percent of the initial investment for everyone (minimum ages apply to qualify). The 65-year-olds mentioned earlier would be guaranteed $5,000 a year to start with a $100,000 investment, less than under annuitization.

With the benefit rider, the income amount can increase if the account value goes up enough to support bigger withdrawals.

Humberto Cruz is a columnist for Tribune Media Services. E-mail him at yourmoney tribune.com.

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