Ep 69: Is Your Annuity in the Wrong Bucket? with David McKnight

February 26, 2020
99.5% of all annuities are not in the right bucket. There are many reasons to use an annuity: they can be safe and productive, they safeguard against market risk while participating in the upward movement, and many people use them for a guaranteed stream of income. The alternative to annuities for c...

Episode Transcript - Is Your Annuity in the Wrong Bucket? with David McKnight

A tax freight train is bearing down on your retirement. To protect yourself, you'll have to harness The Power of Zero.
Hi there. David McKnight. Welcome to The Power of Zero show. I'm your host. I'm grateful that you're back with us for yet another week. We're closing in on our 70th straight episode. That means every week on Wednesdays, you get another edition of The Power of Zero show. We’re grateful that you are with us and you're interested in learning more about The Power of Zero Paradigm. I am the best-selling author of The Power of Zero, Look Before You LIRP, and The Volatility Shield, as well as a new book coming up in February of 2021 through the Portfolio imprint of Penguin Random House.
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You'll notice that the title of today's episode is “Is my annuity in the right bucket?” The reason I titled this podcast that way is because I've found that 99.5% of all annuities are not in the right bucket. Now, there's a couple of different reasons why you might want to have an annuity, I think that some people use annuities because they're safe and productive, particularly if bought in the form of a fixed-indexed annuity. They can be safe and productive. They might grow between 3% and 5% per year. That can become the bond portion of your portfolio. It safeguards, it gets market risk, and guarantees that you'll never lose money while participating in the upward movement of a stock market index up to a cap or maybe, you get a participation rate, what have you, or spread.
That's one way that people might use an annuity. But another way that people might use an annuity is to have a guaranteed lifetime stream of income. I think mathematicians and economists are increasingly starting to recommend annuities for the express purpose of creating a guaranteed lifetime stream of income. Now, we'll go back to what we've talked about in some of our past podcasts; if you're not willing to use an annuity to guarantee a lifetime stream of income, then the other alternative is to use the stock market.
Now, the stock market, if you're trying to combat longevity risk, in other words, the risk that you may outlive your money, then you have to live by a certain set of rules if you're trying to accumulate enough money that will, from a probability perspective, make sure you never run out of money. Historically, that rule that you've had to live by is the 4% rule. We talked about this, I believe, two weeks ago, “Is the 4% rule still viable?” The answer is no, it's not still viable because the 4% rule was established by William Bengen back in the early 90s when bonds were growing at 5.5%, now we're looking at around 2%.
When you factor in the reality that bonds are giving us much lower rates of return, you're not going to get the returns you need to be able to get your money to last as long using the 4% rule. Whereas with the 4% rule, if you need $100,000 per year to live, you'd have to divide 0.04 into $100,000. What you find is that you need $2.5 million starting at the beginning of retirement, day one of retirement, and that used to give you a reasonable expectation adjusting for inflation that you'd be able to maintain that $100,000 lifestyle over time.
Now, given the low-interest-rate environment, the economists and mathematicians are basically disavowing the 4% rule, they're saying now it's more like the 3% rule. How do you figure out how much money you need by the first day of retirement to be able to live off of $100,000 per year? If you use the 3% rule, you divide 0.03 into $100,000 and you get $3,333,333.33. That's how much you would have to have day one of retirement to realistically expect that you could draw that $100,000 out rain or shine, adjusted for inflation and realistically, not run out of money before your life expectancy.
What we found is that it's a pretty expensive proposition. To be able to pay for that $100,000 lifestyle, you'd need a lot of money. Guess what, if you start doing the math and you figure out, “Hey, I'm not going to get to $3,333,333.33 by day one of retirement,” then you've got five options, you can save more, you can spend less, you can work longer, you can die sooner, or you can take more risk in the stock market. None of those five alternatives, particularly, number four, die sooner, seems to appeal to a lot of people. But there may be an easier way, there may be a better way, and that is by utilizing an annuity.
One of the more common ways that people might deal with this is they might do it by way of what's called a SPIA or a single premium immediate annuity. What a single premium immediate annuity says is you give a big lump sum of money to an insurance company and they will, in exchange for that, give you a stream of income that they guarantee will last as long as you do.
Now, one of the appealing parts of this is that it's not going to cost you nearly as much money. You're not going to have to give the insurance company $3,333,333.33 to get that $100,000 adjusted for inflation each and every year. It's going to be considerably less. Now, what's the downside? The downside is that if you die 10 years into this thing, that's it, game over, your money is all gone.
The flip side is that if you live to 120, that's going to keep paying out day in and day out, year after year so long as you're alive. Once you get past average life expectancy, you start partaking in what we call mortality credits. Mortality credits are basically, “Hey, look, some people are going to live shorter than the average life expectancy, some people are going to live longer than the average life expectancy. The people that live longer than the average life expectancy are basically utilizing the money that the people who lived the shorter life expectancies weren't able to use.”
Not everybody uses a SPIA, some people say, “Hey, look, I want to be able to have my income not locked into a fixed amount but I want it to grow over time,” so they'll use the fixed-indexed annuity that can grow over time. The growth of that income is linked to the upward growth of a stock market index, maybe the S&P 500 or some combination of stock market indexes. Whatever the reason you purchase an annuity, whether it's safe and productive growth, a hedge against a downfall in the market, or for a guaranteed lifetime income, I think they're both noble reasons, but what I found is that 99.5% of all annuities that I come across are in the tax-deferred bucket.
This is problematic and I've explained why in past podcasts but I'd like to reprise that discussion here. Here's the deal, let's say that you decide to draw an income, maybe it's a guaranteed lifetime income out of your annuity. It's going to feel like on paper, that is coming out of a pension. Now, if you remember from, I think, Chapter 8 of The Power of Zero, what happens if you have a pension in the 0% tax bracket? There are two things that happen. Number one, because the pension is always coming out of your tax-deferred bucket, it's exposed to tax rate risk, and we've talked until I'm blue in the face about the likelihood that tax rates even 10 years from now being dramatically higher than they are today.
When you take a pension out of the tax-deferred bucket, it's exposed to tax rate risk. In other words, if tax rates double, you keep half as much as you might normally keep. The same thing holds true when you take a distribution from your annuity. If you draw a lifetime guaranteed stream of income out of your annuity, it is guaranteed to come out of your tax-deferred bucket if that's where it started. If tax rates go up, the portion of that income that you get to keep actually goes down.
Now, the reason why people are getting this guaranteed lifetime stream of income is because they're trying to have a guarantee that that stream of income will cover their lifestyle expenses when coupled with their Social Security, 100% of their lifestyle expenses. Guess what, if tax rates rise dramatically, like we fully intend that they will, then you're not really going to be covering your lifestyle expenses. What are you going to have to do? You're going to have to tap into your non-annuity assets, maybe in the stock market, maybe in bonds to be able to compensate for this lack of income due to rising taxes. That could force you to spend down all those other assets a lot faster. You may run out of money a lot faster.
Remember, those spare dollars are designed to pay for aspirational expenses which I define as things like going on trips around the world, shipping all the grandkids to Disney World, or what have you, those are what I call aspirational expenses. But they also are earmarked for shock expenses. This could be a long-term care event, this could be you got to fix the roof, you've got to give some money to a family member that's really struggling, or unanticipated healthcare expense. We get shock expenses and aspirational expenses that you're going to need that pool of non-annuity assets to help pay for until you die. Those expenses will never go away. What happens is when you draw your annuity out of your tax-deferred bucket and tax rates go up, you have to spend down this important pool of financial resources to compensate for it. That money's going to run out much faster than you ever, ever thought.
That's part one. What's part two? Part two is that like a pension, if you elect that stream of income out of your tax-deferred bucket, it's going to count as provisional income which counts against the thresholds which determine if your Social Security is going to be taxed. What happens if your Social Security gets taxed? By the way, if you have too much provisional income, you might have a Social Security tax bill between $5,000 and $7,000. How do most people go about plugging the hole in their Social Security? By spending more money out of their 401(k)s and IRAs out of their stock market portfolio, out of their non-annuity assets to be able to compensate for that hole in their Social Security.
I've found that when your Social Security gets taxed—by the way, I've done hundreds of these calculations over my career—you run out of money five to seven years faster than people who do not have their Social Security taxed. Why? Because the act of compensating for Social Security taxation forces you to spend down all your other assets that much faster. If what I say is true that 99.5% of all annuities get sold within the tax-deferred bucket, this is a problem because it's going to force people in a rising tax rate environment to pay Social Security taxation, they're going to keep less of their income that they thought they would, and it's going to force them to spend down all of their other non-annuity assets that much faster.
That's why I titled this podcast “Is your annuity in the wrong bucket?” because there is a way to get that annuity into the right bucket. Now, most people, when they retire, have 401(k)s or IRAs and they roll that into an annuity in the tax-deferred bucket. If you are like most of the annuity companies out there, that's where it ends, you're stuck, the money's stuck in the tax-deferred bucket because while these companies do have Roth conversion privileges, they typically force you to do the Roth conversion all in one year.
What are the implications of that? If you do your Roth conversion all in one year, you're going to rise rapidly in your tax cylinder and you're going to end up paying taxes at the highest marginal tax bracket plus state so you can be paying upwards of 45%, if you're in California 50%, to be able to get that money shifted all in one year to the tax-free account. This is why I think it's really, really important that if you're going to use an annuity, you use an annuity that has what I call an internal piecemeal Roth conversion feature.
What that means is that allows you to keep the money in that annuity but do the Roth conversion at your leisure. In other words, just like we've talked about on The Power of Zero in another podcast, how quickly should you be converting money to Roth IRA? You want to do it quickly enough that you do all the heavy lifting before tax rates go up for good, but you want to do it slowly enough that you don't rise so dramatically in your tax cylinder that it gives you heartburn. There's a right amount, I call that the magic number. That's the amount that you should be shifting each and every year so that you get all the heavy lifting done. I've got a magic number calculator at, if you want to go, check it out. That'll tell you how much you should be shifting each and every year so that you can get to the right balance by the time tax rates go up for good.
There are only about four companies that I've been able to find that allow you to do an internal Roth conversion feature. What that allows you to do is it allows you to get that annuity shifted to tax-free, shifted to a Roth IRA so that by the time you elect the guaranteed lifetime income, that money is going to come out 100% tax-free. It's not exposed to tax rate risk, it's not counting as provisional income, it's not going to cause Social Security taxation. You're not going to be forced in a rising tax rate environment, you're not going to be forced to spend down all of your other stock market or non-annuity assets to compensate for this additional taxation because you left the money in the tax-deferred bucket. It's all in the tax-free bucket which allows you to preserve your other pool of stock market and bond resources.
What it also allows you to do if you have a guaranteed stream of income coming out of your tax-free bucket is it allows you to take much more risk in the stock market. Why? Because once you have your guaranteed stream of income solidified out of your tax-free bucket and it's not exposed to tax rate risk, guess what, you now have a permission slip, you now have the luxury of watching the stock market go up and down. You're not as constrained to take money out of that account should you need extra money in a given year because you can just let that stock market recover, thereby, not exposing you to what we've discussed in the past as sequence of return risk which is what happens when you take money out of your stock market when the stock market is down, it can send your stock market portfolio into a death spiral for which it never recovers.
The long and the short of it is there are all sorts of positive things that accrue to you as a result of drawing a tax-free stream of income out of your tax-free bucket as opposed to being stuck in the tax-deferred bucket where in a rising tax rate environment could cause Social Security taxation, that could cause increased taxation on that guaranteed stream of income that you are relying on to be able to meet all your lifestyle expenses when coupled with Social Security over the course of your lifetime.
That's why I say, “Is your annuity in the wrong bucket?” Probably, yes. I guess this is a word of warning for those of you who are contemplating getting an annuity that you really need to ask your advisor “are you getting an annuity that is going to require you that it stay in the tax-deferred bucket forever?” Unless you do the all-in-one-year Roth conversion. Frankly, I don't think the all-in-one-year Roth conversion is a good alternative for people who are looking to have a tax-efficient retirement.
If you're contemplating getting an annuity whether for lifetime guaranteed income or as a bond portion of your portfolio as a protection against market risk, simply ask your advisor this question, “Does my annuity allow for internal piecemeal Roth conversions?” In other words, do I have the luxury of shifting money to a Roth IRA within that annuity at my leisure or do I have to do it all in one year?
If you are looking for someone that can help you navigate all of that that's familiar with all those companies, that can help you get to the 0% tax bracket, and elect that guaranteed lifetime stream of income, we're happy to help you with that. Go to, we're happy to hook you up with an advisor who can help you navigate all that because remember, there are a lot of pitfalls standing between you and the 0% tax bracket. If you violate a threshold on the left side, you might trigger taxation on the right side. There are all sorts of different thresholds that you have to obey. There are different provisions that these products have to have if we're going to be able to accomplish everything that we're setting out to accomplish in The Power of Zero paradigm.
That's the show for today. We appreciate you being with us. Again, subscribe. If you do, you're going to get an email alerting you to the title of the episode and giving you access to it in your favorite podcast medium by way of an email. Again, if you want to get bulk discounts on any of my books, go to Please, give me a follow on Twitter. I would really appreciate a follow, it's at @mcknightandco. Other than that, I appreciate you sharing some time with me today. We'll look forward to chatting with you next week.

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