An Alternative to Tax-Free Bonds
While tax-free bonds can be a popular source of tax-free income, some retirees are not aware that they can receive a potentially higher source of cash flow from insurance companies.
This source of money is from an immediate annuity. In exchange for the premium payment, the insurance company pays the annuity owner a cash payment for life or for a term of years. Each of these payments is comprised of interest and principal as determined by an actuarial calculation set forth in Section 72 of the federal tax code. The principal portion is not subject to income taxation. Once the owner has recovered his or her investment, the remaining payments will be taxed as ordinary income.
Let's take a look at the hypothetical case of Mr. Jones, age 70 with a $500,000 portfolio of municipal bonds, earning 2.85% federal tax free. He receives $14,250 of annual tax-free income (2.85% x $500,000).
He decides to cash in his tax-free bonds and pay a premium to an insurance company of $500,000 for an immediate fixed annuity. With the immediate annuity, his yearly cash payment from the annuity would be $38,463 per year of which 81% is tax free (the tax-free portion of an immediate annuity is the part the IRS considers return of your principal and is based on your life expectancy and the expected return). After taxes, he will have $36,610 to spend. His spendable cash using the immediate annuity over the tax free bonds increases by $22,360 annually ($36,610-$14,250).
So in this particular example, the yearly cash flow has increased by using the fixed immediate annuity. Of course, your results will vary based (among other things) upon your age, health, relative yields on annuities and tax free bonds and premium payment. The payments in this example shown above are calculated on the life expectancy of the annuitant and the spot interest rates effective for the month of purchase under the contract. The spot interest rates can vary from month to month. The payments shown above are not subject to mortality fees, administrative charges, or other expenses. However, actuarial calculations, life expectancy assumptions, and interest rates can vary from insurer to insurer. Therefore, your results will likely vary from the examples shown above.
However, an immediate annuity will usually not leave anything for your heirs unless you purchase from a company that offers a refund feature. This refund feature will typically reduce the size of the monthly annuity payments. The amount of the refund could also be reduced by surrender charges in some cases. Therefore, the immediate annuity is generally better suited for people who place more importance upon increasing lifetime cash flow.
In some cases, an immediate annuity can produce more after-tax cash flow than tax-free bonds. Of course, the benefit of increasing your cash flow does involve a number of other trade-offs. Note that the difference between municipal bonds and immediate annuities are:
- Immediate fixed annuities have a stated payout for a stated period of time and municipal bonds have a fixed interest rate for a fixed term.
- Municipal bonds may be callable, while immediate fixed annuities are not. Municipal bonds may be subject to AMT taxes if your income exceeds certain amounts. You should consult with your tax advisor about this.
- The purchaser of municipal bonds incurs a commission. Premiums for immediate annuities include commissions, fees, and potential surrender charges.
- The payments in a fixed immediate annuity are guaranteed by the annuity claims paying ability of the insurance company, while the payments from a municipal bond are guaranteed by the issuing municipality.
- Part of each immediate fixed annuity payment is tax-free because it represents a return of the principal, while all of the interest from most municipal bonds is completely exempt from federal tax and may be exempt from state tax. Municipal bonds may be subject to AMT taxes if your income exceeds certain amounts. You should consult with your tax advisor about this.
- Immediate fixed annuities cannot be redeemed and are liquid. Most municipal bonds can be sold at any time on the secondary market at a gain or loss. When held to maturity, the issuer guarantees payment of face value of a municipal bond.
- Immediate annuities provide a source of cash payments for life or the selected term while municipal bonds provide semi-annual interest until maturity or until called.
- At death, the payments from an immediate fixed annuity stop unless for a certain term and there is no residual value. At death, a municipal bond is included in the estate of the owner.
Free Online Resources
There’s no substitute for carefully reading the prospectus of a mutual fund or variable annuity before making a purchase. Regulatory agencies such as FINRA and Securities and Exchange Commission (SEC) offer a variety of free online resources to assist the investing public, here are a few:
FINRA Investment Choices
FINRA Variable Annuities: Beyond the Hard Sell
FINRA Understanding Mutual Fund Classes
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