Taxes have been imbued in the American consciousness since the founding of the Republic. In fact, taxes caused the founding of the Republic. Ironically, many investors (and their advisors) seem unaware of how taxes are a major retirement risk along the lines of inflation and healthcare. Actually, for those in the highest brackets, taxes will be the greatest expense they have in retirement. And with rates inevitably rising at the federal, state and local levels taxes will become problematic for virtually every retiree.
As an early advocate of Roth conversion, a certain blogger was surprised by how little of the conversion discussion focused on how to invest those assets once they were safe from the clutches of Congress. Roth conversion presents a brave new world to retirees previously confined to municipal bonds as their sole source of tax free income. So as a public service announcement please be advised the remainder of this post contains references to annuities that have been known to cause drowsiness due to the guarantees they provide.
On the surface, a single premium immediate annuity (SPIA) in a Roth IRA may seem as horrifying as drinking Jack Daniels with coke. But after a few sips it just might grow on you so consider the following. Allocating a portion of a Roth IRA to an immediate annuity is a way to generate tax-free income that can't be outlived. Add an inflation rider which most SPIAs have and you've addressed three of the biggest risks faced by any retiree: longevity, taxes and inflation.
It gets better. Unlike a municipal bond, SPIAs are not callable and several of the insurance companies that issue them have AAA ratings (if you still believe in that sort of thing) - a nice way to diversify and upgrade the credit quality of your tax-free sources of income. This strategy should be particularly compelling if your state and city have the temerity to tax your income. As the old Lebenthal ads used to say about municipal bonds, "It's not what you make, it's what you keep." This is especially wise advice in an environment where low interest rates are rewarding borrowers while punishing retirees stretching for yield. A back of the envelop example helps make the case.
A 65 year old male can generate about $600 a month by investing $100,000 in a SPIA. That's $7,200 a year in tax-free income if the annuity is purchased with Roth assets. For someone in a combined 50% bracket (federal, state and local) that's a taxable equivalent yield of over 14% - an intoxicating number that hasn't been seen since the Reagan administration. It's important to note this isn't an apples to apples comparison because a portion of the SPIA payments represent a return of principal which wouldn't be taxable regardless of the source of funds. This is called the exclusion ratio. However, upon reaching your life expectancy, all of the annuity payments would be fully taxable unless purchased with Roth assets.
Of course drinking Jack Daniels has consequences as does annuitizing Roth assets. First, annuitization has to be right for you regardless of the type of account where the assets are held. SPIAs also mean you hand your money over to the insurance company in return for the guaranteed paycheck. However, many do provide some degree of flexibility in terms of returning a percentage of your investment or guaranteeing payments for a certain period of time should your demise come earlier than expected. Naturally all this comes with a cost in the form of reduced payments.
Then there are the killjoy pundits who rail at the idea of tapping Roth assets until the apocalypse and maybe not even then. Understood, but surely the sanctity of Roth assets should be reconsidered based on the unique needs and circumstances of the individual. And with the inevitability of higher taxes this concept shouldn't be dismissed out of hand. In fact, the retiree who annuitizes their Roth will have more than enough to buy a JD or two. Just be sure to do both responsibly.
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