FINANCIAL PROBLEM SOLVED!

"I need another retirement vehicle"

Problem

My retirement portfolio is pretty substantial, but I'm a cautious person, and I'd like to have as much set aside as possible when I retire in 10 years. I've maxed out my 401(k) contributions. Am I better off putting whatever additional money I can into taxable investments, or should I get a tax-deferred annuity?

Solution

If you're already making the maximum contribution to your retirement plan, a tax-deferred annuity might indeed be a good bet. Under the right circumstances, an annuity can be an excellent way to supplement income, because avoiding current tax on the earnings can really save you a bundle.

First, a review of the basics: With a tax-deferred annuity, you pay a lump sum today, make periodic payments over time, or both. The insurance company invests the money for you, and the earnings on it aren't taxed until you start taking your monthly annuity payout after age 59 1/2.

Besides tax-deferred growth, annuities offer another plus: You can defer withdrawals from them—until age 95 in some new contracts—so you get the full benefit of tax-deferral. In contrast, you generally must begin taking distributions from your retirement plan at age 70 1/2.

Some new annuities also offer a unique feature called a step-up benefit. If you die before payouts from your annuity begin, the company guarantees to pay your family the highest investment value the annuity has reached, by locking in investment gains every year or every few years. For example, say you invested $100,000 in 1995, and the value was locked in at $260,000 in 2001 but has since fallen to $145,000. If you die, your beneficiary would receive the locked-in $260,000 rather than the current lower value. You'll pay extra for this benefit, though, usually about $200 more per $100,000 annually.

Right now, some highly rated fixed annuities pay around 3.5 to 4.5 percent interest—more than money-market funds and short-term CDs average, even before you consider the value of deferring the tax.

On the other hand, over the long term you might do better with mutual funds if the market rebounds. That's one tradeoff you make to get the safety and security of the annuity payout. To get the best of both worlds, you might want to buy an annuity that invests in growth stocks, so you can share in any market increase.

Another drawback to tax-deferred annuities is the fact that the annual fees they carry can be expensive. Stay away from the annuities that tack on a front-end sales charge.

Most annuities also hit you with a back-end surrender charge if you cash them in. The surrender charge usually declines annually and ends after seven years; however, some last for 15 years.

Often, the biggest stumbling block for a high-income investor is time, because despite the tax deferral on earnings, it usually takes five to 15 years for an annuity's tax benefits to outweigh the fees. You say you're 10 years from retirement. If you plan to take the money out in a lump sum, that may not be long enough for you to benefit from the tax deferral; the high tax rate you'd pay on that distribution could wipe out the tax savings. You might do better by taking periodic distributions to shrink the tax bill.

This month's problem solver is Mark Lowe, CFP, ChFC (markl@montaukfinancial.com), a financial adviser with Montauk Financial Group in Red Bank, NJ. Financial Problem Solved! is edited by Senior Editor Leslie Kane.

Do you have a question you'd like a financial adviser to address? Please submit it via e-mail to Solved@medec.com, or by regular mail to Medical Economics, 5 Paragon Drive, Montvale, NJ 07645. ATTN: Financial Problem Solved! If we select your query, we'll address it in an upcoming issue. Your name will not be used.

Leslie Kane. Financial problem solved! "I need another retirement vehicle".

Medical Economics

2003;7:104.