HYBRID PLANNING TOOL – COMPOUND INTEREST AND IMMEDIATE PAYOUT
There are some retirement strategies that people engage in that have many benefits one the one hand with a similar amount of disadvantages on the other. Life is like that, it involves trade offs and often you get what you pay for. There are exceptions, however, especially in financial planning products. The only limits are the laws and the creativity of investment managers. With respect to the laws, the main concern that investors should consider is the tax liability, which can vary depending on what form of investment is generating income with the invested money.
Annuities are investment products that generally either guarantee a specific rate of return and start to pay immediately for a specified period of time, or, the funds are placed in an account where they accumulate tax deferred as an investment and then converted into an annuity and withdrawn in accordance with the annuity plan. The former type of annuity is called an immediate annuity, while the later is called the deferred annuity. An immediate annuity is generally taxed up prior to deposit of the funds, while the payout of the annuity is not considered a taxable event. With respect to the deferred annuity, the payout, minus the principal, is a taxable event. If the money is withdrawn from the annuity prior to the age 59 1/2, the amount is generally subject to a 10% tax penalty. A split annuity, however, is a financial product that couples these two types of annuities together.
Deferred annuities are good for investors who are seeking to insure that their income will both earn a return and have a low tax liability. Purchasing municipal or other governmental bonds to fund your annuity will help ensure low or no tax exposure. Allowing your investments to grow and reinvesting all earnings shows that you will be in it for the long haul. This is always best due to compound interest. Certainly all bonds come with some measure of risk, despite the preferential tax treatment that they receive under federal tax law. If growth is what is sought, with the hope that the investment will still net more than the tax liability and other fees would net compared to a tax free bond strategy, the investor is still insulated from the volatility of the stock market. One way to reduce the tax bill is to the deferred annuity to pay some of its earning to a charity. The immediate annuity further insulates the investor from the various ups and downs that come with so many investment vehicles. In order to balance this risk out and to maintain a regular stream of income, the other half of the split annuity allows for immediate payout of a predictable stream of income.
In retirement most people rely on social security, retirement income from a pension or other similar vehicle as well as personal savings. Utilizing a split annuity allows a person or couple to supplement these sources of income. Furthermore, it is a very flexible tool that many people can use to fit the specifics of their life.