Converting Assets to Income

Systematic Withdrawals

A systematic withdrawal is a regimented way to convert an asset to income over the lifespan of the recipient. It can also be used to produce income over a certain number of years. The withdrawal is based on a calculation of receiving a fixed monthly income over a certain period of time - which might be the life expectancy of the recipient - with the balance of the account earning a certain presumed rate of return. The idea is to maintain an account balance over that period based on the withdrawal and the earnings of the remainder in the account. Systematic withdrawals can also be set up to incorporate monthly amounts that increase each year to keep pace with inflation.

Systematic withdrawals are particularly useful in accounts that have some volatility such as stock accounts or mutual funds that contain stocks. The concept is that withdrawing a fixed amount each month will sometimes be done when the account is down, but that will be offset by times when the account has done well. The overall effect on the account results in an averaging effect that could produce more income than just simply taking the money out and transferring it to a fixed account for income purposes. The reason for this is that the timing of large withdrawals from an account that is going up and down with the market is difficult to determine. One never knows when the market is reached its high and taking the money out prematurely may have the effect of not letting the account reach its maximum potential from positive earnings.

Another useful strategy for systematic withdrawals is incorporated into some deferred annuities. The deferred annuity is specifically designed for producing a systematic withdrawal income that is not penalized as an early withdrawal. The income is not a result of the annuitization of the account but simply a monthly fixed amount withdrawn from the account. The advantage of this type of income is that the underlying deferred annuity - during certain periods of low fixed interest - can produce a slightly higher interest rate of return and this allows the underlying asset to last longer and produce more income before depletion.

Asset Allocation Strategies for Maximizing Income

Another useful strategy for producing income from assets is to divide the money in two separate accounts - one earning a fixed interest rate of return and the other invested more aggressively in stocks and long-term bonds. The aggressive account could be a stock mutual fund. The actual percentage of the assets in each account is predetermined based on the period of time income will be produced. This income interval of time could be the life expectancy of the person producing the income for himself or herself. Typically, the longer the income interval of time that income will be produced, the smaller the percentage of assets in the fixed account versus the aggressive account.

Over long periods of time, stocks and long-term bonds have historically produced greater rates of return. By putting a larger portion of the assets in these types of investments, the potential is for the assets to grow larger than they would have if they were 100% in a fixed interest account. The problem is that if the aggressive account is used solely to produce income using a systematic withdrawal, there is great risk that in down markets the withdrawals could eat into principal - if the downturn lasts too long - and thus deplete the account prematurely.

The strategy is to have enough cash in the fixed interest account to bridge down markets. The fixed interest account is used to create a systematic income withdrawal and the aggressive account is used as a growth vehicle for transferring money into the fixed account. The fixed account would contain enough money to produce a predetermined number of months of income - say for example 60 months - through systematic withdrawals. At some point during that predetermined income period the account will be replenished to a predetermined level to perpetuate the predetermined number of months of income indefinitely. The replenishment would be timed to take money out of the aggressive account when markets were showing a positive return. The idea is not to outguess when the top of the market has been achieved, but simply to take money out at a predetermined market performance and not worry whether the timing was perfect.

Immediate Income Annuities

An annuity is a guaranteed monthly flow of income over a certain period of time. This period of time can be fixed at say five years or 10 years or 20 years. This is called a period certain annuity. If the annuitant dies before the end of the payout, the balance is paid to a designated beneficiary. Or the guaranteed income can be paid out over the life expectancy of the person receiving the payments (who is called an annuitant). This is called a life annuity. Or the income can be paid out over the combined life expectancy of the annuitant and any other person. This is called a joint life annuity.

An annuity is created by paying an insurance company a fixed amount of cash and the insurance company will create a contract between the annuitant and the company that guarantees a certain flow of money each month for the designated period of time. By purchasing such a contract, the annuitant has, in most cases, lost all access to the original cash used to purchase the income flow. If the designated period of time is the lifespan of the annuitant, the insurance company has to rely on actuarial experience in order to create the income flow. If the annuitant lives longer than the period of time that the insurance company actuary thinks he or she should live, the insurance company loses money. If the annuitant dies sooner than the insurance company actuary thinks he or she should live, the insurance company makes profit. In essence, a life annuity is like a reverse life insurance policy where the benefit is paid out over time. This is why annuities are sold by insurance companies because they are in business to take risks on the occurrence of future events.

The annuity payout is based on dividing the lump sum amount by the number of months for the contract and adding onto this calculated amount the monthly interest earned by the insurance company on the balance not paid out. A purchaser of an annuity does not have access to the lump sum used to purchase the annuity and under most cases the guaranteed income stream is the only option. This contract is often called an immediate income annuity or a Single Premium Immediate Annuity (SPIA). We will call this concept an income annuity for brevity.

Annuities can be useful tools for creating retirement income. The most obvious is where the annuitant is in good health and anticipates living a long time. There is still a possibility of dropping dead due to some acute occurrence, but the annuitant feels that purchasing a life income annuity would guarantee an income that would never run out until the annuitant died. This guarantee, is especially comforting to some older people who are worried about running out of income.

Another useful application of an income annuity is in getting money out of a deferred annuity. The account balance in a deferred annuity that has been around for a long time might contain a great deal of earnings. Those earnings have been free of income tax while they have been inside the deferred account. Unfortunately, current tax laws are not very friendly towards withdrawals of money from deferred annuity accounts. For example, suppose that the annuity is worth $60,000 and $30,000 of that was the contribution and the other $30,000 represents the earnings. Under current tax law, any withdrawals up to $30,000 in this account are considered earnings first and the other $30,000 are considered contributions. Thus, the first $30,000 withdrawn from the account are 100% taxable at ordinary tax rates. Large withdrawals could wreak havoc with the total income tax due for the person who owns such an account by pushing that person into higher tax brackets.

Systematic withdrawals from the annuity account don't solve the problem either. Whether the money is taken out as a lump sum or as monthly payments, the first $30,000 is still 100% taxable at ordinary tax rates. By the way, many seniors often don't take money out of their deferred annuities because of this tax hit, and they keep the money in the annuity in order to pass it to their children. This is a poor strategy for transferring money to the next generation because the children inherit the tax hit. In our example, the children inheriting this annuity of $60,000 might well lose $20,000 of the investment to taxes, depending on tax rates. Not a very good estate planning strategy.

A good solution to getting money out of the annuity and reducing the taxes is to annuitize the deferred savings account - convert it into a guaranteed income stream. Under IRS rules, the monthly payout includes both the principal and the earnings. In our example, annuitizing the $60,000 in our deferred annuity example over 60 months might produce a monthly income of $1,100 a month. But in this case, the $1,100 a month is not 100% taxable. For IRS purposes, the payout is calculated to include $550 a month in nontaxable principle and $550 a month in taxable earnings. Converting to a guaranteed income stream - an income annuity - cuts the yearly tax hit in half.

Income annuities are also a useful way to take money out of qualified retirement accounts. This might include IRAs, 401(k)s, tax-sheltered annuities, and other qualified retirement plans. The money in these accounts is 100% taxable. Not only are the contributions taxable but the earnings are taxable as well. For some seniors, withdrawals from qualified accounts can result in losing 40% to 50% of the account to taxes. No matter how you cut it, you can't get around taxes on withdrawals whether that they are systematic or whether they are in the form of an income annuity. The income annuity planning advantage comes into play when we consider how money has to be taken out of a qualified retirement plan.

Required Minimum Distributions

All qualified plans, under IRS rules, must pay out a yearly minimum amount when the owner turns age 70 ½. These mandatory withdrawals are called by the IRS, Required Minimum Distributions or for short RMD's. For someone age 70 ½, the amount of money that must come out might only represent about 5% of the account balance. But, as a person grows older the RMD as a percentage of the account balance increases. For example, an 85-year-old might have to withdraw 8% of the account balance. What this means for older individuals with large tax qualified account balances, is that their taxable income goes up every year as they grow older. When they started these accounts while they were still working, they never anticipated having to pay higher taxes as they grew older.

An income annuity can solve this problem. Under IRS rules, annuitizing an IRA or other qualified plan account will levelize the annual withdrawals. For example, an annuity income from an IRA might represent a yearly withdrawal amount of 6% of the account balance. But this percentage does not go up. In fact, in relation to what the account balance would be - even though it is not accessible - the withdrawal amount percentage actually goes down each year. This certainly helps with the tax hit from IRA withdrawals for older individuals. The IRS is also very liberal about the period of time used for the annuity. For example, the life expectancy for an IRA income annuity from IRS tables could result in a payout over 15 years for an 85-year-old. If the annuitant dies before the end of the payout period the balance of payments goes to a designated beneficiary.