Paul Winkler: Welcome to “The Investor Coaching Show.” I’m Paul Winkler, talking about money and investing, educating, and letting you in on some of the investment industry secrets—because the more you understand this stuff, the less you’re going to get taken advantage of.
Will You Outlive Your Money?
I was talking to a lady today, who listens all the time, and I said, “Do you understand?”
She said, “No, I don’t understand everything, but it’s entertaining, number one,” because I like to joke around, I suppose, when it’s appropriate, “but also because you’ll pick up something.” And I appreciate that. So I just appreciate those comments because sometimes I wonder, am I going over their head? I’m going to try not to.
There is something really, really important I want to talk about right now. I got a mailing and the mailing was to go to a steak dinner. Thanks for the steak dinner, folks, the financial planners who are trying to invite me out to dinner, but no thanks. But you have given me something really good for the radio show because now I have to advise people, take me off your mailing list if you’re a financial planner trying to get me to go to your steak dinner, it’s really bad for your business for me to get your invitations because I’m going to pick on them.
I was taught to do the same thing back in the day, I never did that, but I was taught. They taught us to go and get people into steak dinners, get them into restaurants, college campuses, because you get the gravitas that comes with the college campus. If you’re teaching a class on the college campus, yeah, it looks like you’re actually endorsed by the college in some way if you’re renting one of their rooms.
So I got this thing and it was talking about the question of: Will I outlive my money? That’s the number one question that retirees or those nearing retirement are asking. And that is very true.
There are a lot of people worried about outliving their money.
When you go to one of these workshops and this particular one, they’re going to talk about access to a source of income that’s rarely considered. It could be, possibly, reverse mortgages, maybe that’s what they’re talking about. Yeah, people don’t typically think about that. I’m just guessing that’s what they might teach. Pay dramatically less taxes in retirement, including no taxes on social security benefits.
Of course, you can go and convert your IRAs to Roth IRAs, pay a bunch of taxes. Now, it’s not that you have avoided taxes, you’ve just shifted it to a different point in time. And sometimes it does make sense, a lot of times it may not necessarily make sense. It really, really depends on the situation. You can pay no taxes on social security, you can have no income, that’ll take care of that as well.
I’m going to take exception to what they’re saying as how to protect against inflation and annuities is really what they’re getting into here and index annuities where you can participate in market returns. And I’m going to hit this in a little different way than I normally do, but I’m going to hit something that I think is really important is how to protect myself from outliving my money.
The Problems with Investment Products
I’m going to talk about a workshop that I taught a little while back. I talked about, hey, this is one of the things the government got right. A lot of people like that particular title because does the government ever get anything right? And yeah, the answer was yes. In this particular case, the way the rules are written to take income from IRAs, it can be very, very beneficially done, the way of taking income, if you follow these rules. I’ll talk about that in a second.
A shrewd tactic to guarantee you’ll never run out of money could be just about anything.
Annuities typically are the way to never run out of money because you actually put money in an annuity and it pays an income to you for the rest of your life, so you can’t run out of money.
But there are problems that you don’t necessarily pick up on when you use these products that I’ve talked about before, but I might talk about in a little different way than I normally get into it. So one of the things that I was talking about was this workshop that I had done a while back.
The workshop was on RMDs, required minimum distributions. Now the idea behind your IRAs or your 401(k)s is you’re putting money away right now. You’re putting it into, let’s say it’s a pre-tax traditional IRA or 401(k) and saying, “Don’t make me pay taxes right now. I don’t want to pay taxes right now. Let me pay taxes sometime in the future when I am not working anymore.”
When I’m not working, my income level is much lower, so therefore, I have some income that I can earn and the tax rate on that is zero. And then, I have some income taxed at 10%, have some income that’s taxed at 12% and 22% and 24%, and the tax rates go up as your income goes up.
Well, a lot of times, when somebody’s working and they put money into a 401(k), they can avoid that 22%, 24%, up to 37% tax rate when they put the money in. So they go, “I got $10,000 and I want to put it away. And if I put it away and I pay taxes on it, and if I’m in a 37% tax bracket, I’ve got $3,700 in taxes that I have to pay right now and I’m only left with $6,300 to invest in something.”
How Do Pre-Tax Investment Vehicles Work?
Well, why don’t I put the full $10,000 into the pre-tax 401(k) or IRA if IRA limits are lower than that? But if I can do that, then I don’t pay that tax right now. That money that would’ve been sent to the government in taxes can earn income for me or returns for me, then I’ll take it out in the future where I get to earn a lot of money, and if I’m married, filing jointly, it’s almost $30,000 where I pay no taxes on it so I can earn income and I have no taxes on it whatsoever.
Next $20,000 approximately of income tax at 10% and so on and so forth. And I look at that and go, Wow, that’d be kind of nice if I could avoid a higher rate right now and then take it at that lower rate, that’s tax leverage. Good deal. Makes a lot of sense. Why pay taxes right now if I’m not using the money right now? That’s the idea behind that.
So that’s why pre-tax types of investment vehicles have always been so popular. Now, if we think about that and now we go and say, okay, so what happens if I go Roth IRA? I’ll be paying taxes now and I may be avoiding lower tax rates in the future. And that’s why Roth IRAs don’t always make sense for people. Now with the required minimum distribution, let me come back to that because the required minimum distribution does not apply to Roth IRAs, but it does apply to pre-tax IRAs.
An investment vehicle that makes sense for someone else may not make sense for you.
So how does it work? Well, what it does is it takes a look at what your age is. Required minimum distributions, the rules have been changed, where if you weren’t already taking them when the rules changed, then what happens, you may be subject to a couple different ages that you have to start taking these distributions. One of them is 73. And then, for people born a little bit later after the 1960s, it’s 75.
So what happens is you’ll have this situation where you don’t have to take it. But what is the formula based on? The formula is based on if you were age 73, they’re imagining that you’re married to somebody age 63, 10 years your junior. So therefore, if you take two people, one 63 and one 73, their joint life expectancy would be longer than someone who’s just age 73 because you got the younger person there.
So what happens is that it reduces the amount of money that has to come out, it reduces the percentage. So the way it works is you take the dollar figure in the IRA, divide it by the life expectancy. And if that number is, let’s just use 25 because it’s a nice easy number to deal with. If I’ve got 100,000 and I divide it by 25, that equals 4. That’s your percentage that has to come out of your account value.
Life Expectancy
Then every year you get older, your life expectancy goes down some, but not completely. Because what happens is like, when you’re born, let’s say that your life expectancy is 76 years old, let’s say that that’s what it is. Well, when you reach age 76, your life expectancy isn’t zero years.
You’ve been through a lot of the junk that takes people out like infant mortality or crazy stuff that kids do or teenagers do, or diseases that come along that take people out in their 20s and 30s and 40s and 50s, and heart disease, and those types of things, cancer, and diabetes, and all of those types of things. So what happens, you made it to age 76, therefore you’ve sidestepped a lot of those time bombs from 0 to age 76, so therefore, you still have life expectancy, okay?
So what happens is they have a life expectancy for you at that particular age, and they will divide your account value by that life expectancy imagining you’re married to somebody, even if you’re not married, imagining you’re married to somebody 10 years younger than you. So what happens is that I can take this income and it’s a percentage of the account value, and I don’t worry about running out of money. Why? Because I’m always taking a percentage of whatever is there and because I’m taking a percentage of whatever is in the account and I’m not taking and running it down, you don’t run out of money in that particular instance.
Now you have to be really careful though what you’re investing in because you may not run out of money, but you sure may run out of purchasing power. And what I mean by that is that, let’s say you’re taking money out of an annuity.
Annuities look at life expectancy.
And in general, let’s say I have a person with a life expectancy of exactly 10 years, and their joint life expectancy, if they do it jointly, it’s 10 years, whatever, let’s just use 10 years, and you hand the insurance company $100,000 and say, “Hey, here’s a hundred thousand dollars. What’s my life expectancy?” They’re not going to tell you, but they’re going to have actuaries that figure it out, and they’ll say it’s 10 years.
So what we’re going to do is, let’s say that the interest rate is non-existent just to keep this really, really simple and let’s say the insurance company has absolutely no expenses whatsoever. So what are they going to do? They’re going to pay $10,000 per year, in my example. Then, at the end of the 10 years, the money would have been gone had you done this trick on your own.
Now if you live beyond the 10-year period, they’re going to have to continue making payments to you because it’s an insurance company. They’re taking the risk that you live longer than your life expectancy. If you only live two years, they’ve only paid you $20,000, you gave them $100,000, you lose, your heirs lose, the money’s gone.
The Way of an Annuity
That’s the way of an annuity. That’s just a really simplified way of understanding this idea of how an annuity is designed to work. And by the way, because you could lose, you could end up having payments only for a few years and die, and the money’s gone, and your heirs don’t get anything, especially as people get older, their desire to leave something to their heirs tends to increase. And they don’t necessarily like that idea, that’s why almost nobody ever annuitize these contracts.
But I’m using that as an example because of the marketing at these workshops as annuities and people saying, “Hey, guaranteed, you can’t ever run out of money. You can’t ever…” So that’s how you get that guarantee you can’t ever run out of money is by doing that.
Required minimum distribution is based on a percentage of the account value.
Now with an annuity, let’s say, and I use the example from, there was this website, I’ve talked to this guy before. He runs this immediate annuities website. And you can get kind of quotes on these types of things, so I like that I can use it as an illustration all the time. But let’s say that I had $300,000, and $200,000 I just had in my IRA in regular investments and the other $100,000 I had in an annuity and I was going to use an immediate annuity.
Now, the way the required minimum distribution works is they’re going to take a percentage of the account value. So if you have a 25-year life expectancy account value divided by 25 is 4%, then let’s say that your life expectancy drops down to 20 years, then it’s going to be a count value. Let’s say it’s 100,000 divided by 20, and that’s 5, so that’s 5%.
So as you get older and your joint life expectancy of the 73-year-old married to the 63-year-old is declining because now they’re 83 and 73 or 94 and 84, so on and so forth. As that life expectancy goes down, the percentage goes up. But you’re getting older and you don’t have as much time left, so you’re taking a higher percentage of the portfolio.
I’m going to get into how those numbers work out based on that workshop that I taught because it’s really cool when you look at it and go, oh man, the biggest thing that I worry about, and here are the numbers behind it, then you start to feel a little bit less concerned about this type of thing.
Immediate Annuities
But let’s say that I had the $200,000 in the regular account, $100,000 in the annuity, and I annuitize it, let’s say. Well, the annuitization of that contract helps me meet that RMD. It’s not included in my required minimum distribution calculation. The $200,000 is considered, and then they’d make me take out 4% or 5% or whatever from that. That $100,000 is based on life expectancy and then it meets it so I don’t have to count it in the required minimum distribution. Now, that may sound good, but in a second, I’m going to come back and I’m going to walk you through how it may not so necessarily be so good, and it can actually be kind of frustrating.
Now, if you go to this website of this one mailing on immediate annuities, the guy actually gives an example. He says, if you transfer $100,000 to an IRA annuity at age 72, you may receive $7,250 a year or 7.25% of your premium and annual income. So you got $7,200 approximately.
It’s important to understand the tax system.
Remember I said when you first start taking a required minimum distribution, they’re going to look at you and I imagine you’re married to somebody 10 years younger, so therefore it’ll be just under 4%. So if I have 7.2%, what does that mean? That means that they’re forcing more out of the account then an RMD would’ve required. Now, the government loves that because they get their tax money earlier, but you may not love it because you may end up paying taxes at a higher rate than you would have, number one. You’re getting more income, but the problem is you’re paying taxes at a higher rate.
And what happens, this is really important to understand about our tax system. If you look at the way the brackets are set up, the tax brackets, your first income is taxed at zero. Remember, it’s like about $30,000, right? Just under $30,000 of income married filing jointly that you don’t have to pay any taxes on. And the next $20,000 is at 10%.
Well, if we look at that and we say, okay, so what happens to those tax brackets? Well, as time goes on and inflation erodes the purchasing power of the dollar, those tax brackets go up or the incomes go up, and then you’re taxed at lower rates for higher and higher amounts of money.
Income Tax Implications
An example to help you understand this is that let’s say if I’m looking back in the 1970s and $10,000 was pretty normal for a family making that level of income. Now, do you think not only could I earn $7,000, or a normal family income, but even another $20,000 above that, I would be taxed at 0% in the 1970s? No, that doesn’t even make sense. We all paid taxes in the seventies, right?
My parents were making normal incomes and paying taxes just like everybody else. They weren’t exempt from them. So why are we exempt from taxes for so much more income now? Because the purchasing power of the dollar has gone down by that much. I mean, you think about it, I couldn’t possibly live on $7,000 now.
What are the implications of this? Well, the implications are that if I’m earning $7,250, which is what this annuity is, $7,250, right now, in 20 years, if I have a 4% inflation rate, the purchasing power is only $3,200. Well, so maybe because of the way tax brackets are indexed, my income taxes will be less, but the problem is that tells you something else. If the income tax brackets are that low in the future, that must mean the government feels sorry for us because it is not even willing to tax us on it anymore because we must be at the poverty level.
Going broke safely is still going broke.
This is just another way of looking at this. I mean, it’s kind of a funny way of looking at it. It’s not that funny. But the problem with these annuities is that you go and annuitize it and then you get the same level of income forever, and that income level may be fine right now, but in the future it’s just not going to be there for purchasing power purposes. And the problem is that we’ve gone broke safely is in essence what we’ve done here.
Now, the other thing is that they’ll have indexed annuities and they talk about that, and there was a really good article, one of the fun companies out there had an article on this, and they were talking about the elements of indexed annuities, that people just don’t really understand.
It said people often misunderstand the calculation of the investment return credited to your account.
Crediting Returns
I’ll tell you where to find this because I have lots of things that I look at with a lot of these big fund companies. This particular article is from Fidelity. I think they did a really good job of explaining the problems here. And they said that one of the elements of the fixed annuities is misunderstood, it’s the calculation of the investment return and how the insurance company calculates the return and how much of the index return is credited to you. This is the key problem. It’s how they actually credit these returns.
Now, number one, they have lots of ways that they actually limit this so that you don’t get a lot of the returns that the market delivers, and they tell you, “Oh, you can actually get benefit and protect yourself from inflation.” Which is not necessarily the whole story because of the problems with crediting returns.
Number one is the cap, and the cap is the upper limit, as they explain here, over a certain period. For example, if the index, let’s say the S&P 500, the Russell 2000, the Europe, Australia, Far East, or whatever index is being tracked.
An index is just a segment of the market.
Now, if the index returns 10%, but the annuity has a cap of 3%, which is not unusual to see, your account receives the maximum return of 3%. And said that many indexes do that. And here’s the one thing they didn’t put here, but let’s say that the market goes down, they can take away all of the up return.
So if the market goes up 10% in one month, so you get 3% of it, but it goes down 4% the next month, now you would’ve had a positive return up 10%, down 4%, you still have a positive return if you own the market. But in this product, if it goes up, you get 3%, if it goes down 4%, they take away the 3%, they won’t make you go below 0. But that’s what happened, you lost all your return even when the market did what it did, and a lot of people don’t recognize that that’s what happens.
Participation rate is another thing. This is where the market goes up 8% and your participation rate is 80%, is the example they use here. Well, 80% of 8% is 6.4% return. That’s the return you get. Sorry, Charlie. That’s what you get, 6.4%. Now, that’s forgetting about the dividends, which I’ll get to in a second because that makes it even worse.
Then they got the spread, margin, and asset fee, so if they have a spread fee of a couple percent, they take away the return there, but most of the time, a lot of times I don’t see where they show visible expenses in these products.
So I’ll go to the next one, bonus. They give you a bonus. “Hey, if you put money with us, we’ll give you a bonus.” Well, where’s that money coming from? They’re not running a charity where they’re bonusing you and increasing your account value. It’s coming from somewhere and it’s coming from you. I won’t get into that because it’s too complicated right now, but just recognize anytime they’re telling you that there’s some kind of a free lunch for buying their product, there’s no such thing as a free lunch.
Advisory services offered through Paul Winkler, Inc an SEC registered investment advisor. The opinions voiced and information provided in this material are for general informational purposes only and not intended to provide specific advice or recommendations for any individual. To determine what investments are appropriate for you, please consult with a financial advisor. PWI does not provide tax or legal advice. Please consult your tax or legal advisor regarding your particular situation.
