IRA vs. Annuity: A Tricky Choice When You Retire
Retiring was easy when most workers were covered by traditional pensions: You cleaned off your desk, bade farewell to colleagues, and waited for your monthly check to roll in. But as more companies have shifted to 401(k) face some difficult choices. Should they empty the pot, roll the contents into an individual retirement account, and try to manage their way to a reasonable rate of return? Or should they convert the money into an annuity--either through their employer or an outside insurer--that guarantees a monthly payment for as long as they live?
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Pension experts believe the bear market, which has eviscerated many workers' portfolios, may compel more retirees to choose the security blanket an annuity provides. Most Americans aren't very good at budgeting or making investment decisions. The consequences of mismanaging your money can be disastrous.
In exchange for that security, you give up control. By putting your savings in an individual retirement account, you determine how the money is invested, and you can withdraw as your needs dictate. In the meantime, your investments continue to grow. You'll have to take minimum annual distributions once you turn 70½, but new tax rules have sharply reduced the withdrawal amount.
The control issue is of enough concern that about 90% of retirees take their pension and 401(k) payouts in a lump sum, then transfer it to an IRA. Of course, you could run out of money, particularly if the market heads south when you start taking distributions (table). Still, many retirees like the ability to take annual or monthly withdrawals from their IRAs based on estimated living expenses--and to withdraw larger amounts for emergencies. With an annuity, you don't have that flexibility. Without another source of cash, you may not be able to cover expenses that arise when the furnace quits or the car breaks down. The argument for a guaranteed income is very compelling, but it's too restrictive. Life is guaranteed to change.
What's sure to change as you age is your health--and this may make an IRA more attractive. If you have an illness, an IRA lets you withdraw for medical costs not covered by your insurance. Lifetime income guarantees, on the other hand, aren't as valuable if you don't expect to live long. If you convert to an annuity with a lifetime payout and make it to 105, you win. But if you die within a few years after annuitizing, the insurer wins, and your survivors and heirs lose. The exception: an annuity that makes payments to your spouse or heirs after you die. But you get a smaller payout while you're alive. By contrast, what you don't spend in your IRA, you can leave to your spouse or heirs, who'll have to pay taxes only on withdrawals for funds under $1 million. Your heirs, other than a spouse, will face estate taxes on funds $1 million or over.
If you still prefer an annuity, your employer could help you set it up. Companies with cash balance plans usually offer an immediate-annuity option, and some will also annuitize your 401(k). The payment amount will depend on your initial investment, the estimated return, and your life expectancy. The estimated return is based on an assumed interest rate. Company pension administrators usually use the 30-year Treasury bond, which now yields 5.00%.
When deciding between accepting your employer's annuity plan or buying one yourself, keep a few things in mind. Women usually fare better in taking their company's annuity. By law, employers must calculate payments based on the average life expectancy of both men and women. Insurance companies use separate mortality tables for each gender. Because women tend to live longer, they receive lower monthly payments by insurer calculations.
You can shop for higher payments outside your company. If you decide that you can indeed boost your monthly payments by buying the annuity yourself, first roll your savings into an IRA. If you simply withdraw the money, you could end up with a big tax bill on your savings. Once the money is safely in an IRA, use it to purchase an annuity.
There is a way to get a guaranteed monthly income without locking yourself in. Annuitize your employer-sponsored retirement plan and use other savings, such as a Roth IRA or taxable investment portfolio, for discretionary expenses. If all of your money is in your employer plan, ask if you can annuitize part of it and take the rest out to invest in an IRA.
I contacted Immediate Annuities.com to buy one of my immediate annuities. They were prompt, very responsive, paid attention to detail, understood my objectives, and were superb when it came to staying on top of seeing the funds transfer and issue of new policy documents through to completion.
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Increasingly, companies are offering this option. If your employer won't let you annuitize some of your savings, you can take the lump sum, roll it into an IRA, and annuitize part of your savings within the IRA. You'll give up some of the advantages of your employer's annuity, which may offer higher payments at a lower cost, but the flexibility could be worth it.
Ideally, your annuity should cover your ordinary living expenses, allowing you to tap your IRA for emergencies and extras. If the market plummets, you may have to postpone your trip to Paris. But thanks to your annuity, you'll still be able to afford a decent bottle of Chardonnay.