50+ Lifestyles

What’s ‘The 4 Percent Rule?’

By Richard J. Schillig, CLU, ChFC, LUTCF
Independent Insurance and Financial Advisor

Heard of the 4 percent rule? Essentially it is a “rule of thumb” suggesting that annual withdrawals of 4 percent from a retirement account each year will provide enough money for about 30 years of retirement. This rule has been criticized for not adequately taking into account lower interest rates, extremely volatile stock and mutual fund markets, taxes and investment fees, rising retirement costs and irregular retirement spending. With today’s slightly higher interest rates and with a continued strong stock & mutual fund market the 4% rule is coming to the surface again with broker enthusiasm. We have some concerns with this resurfacing rule.

Retirement trends today indicate retirements beginning much earlier than age 65. Further life expectancy today is greater than ever before. The reality of living beyond 30 years is clearly a risk faced by many early retirees. Consequently our split annuity arrangements continue to provide for a much improved strategy for lifetime income with longer life expectancy.

A split annuity isn’t really one annuity, but a combination of two or more annuities funded with a single sum of money. A portion of the money is placed in an immediate annuity that makes a fixed payment to you for a fixed period of time, such as five, seven or ten years. The balance of the money is invested in a fixed-interest deferred annuity, which accrues sufficient interest to equal the beginning sum used to fund both annuities by the time the immediate annuity payments stop. The amount of income you receive depends on the amount of money paid into each annuity, and the terms and interest rates applicable to each contract.

We recommend split annuity arrangement often for both qualified and non-qualified money. There are clearly significant income-tax benefits for both however non-qualified money enjoys much greater benefit. As important is the benefit of preserving the principle for lifetime income purposes with both qualified and non-qualified money. Our fixed-index annuity strategy provides guaranteed principle regardless of stock or mutual fund market volatility.

Let’s look at the income tax benefits for non-qualified annuities. The tax code treats payments received from an annuity as being divided into two parts: a nontaxable portion that represents the return of premiums paid into the annuity, and a taxable portion that corresponds to the earnings in the annuity. As a result, only a portion (i.e., the earnings) of each payment is included in your gross income. The remainder is a return of principal and not taxed. Within the annuity this remainder is referred to as the ‘exclusion ratio.’

The ‘exclusion ratio’ is a huge income tax benefit. An additional annuity benefit is ‘income tax deferral. Earnings on a fixed-interest deferred annuity (i.e., the interest earned on your money) remains tax deferred until withdrawn. Unlike most taxable investments, you pay no taxes on your annuity earnings until you begin to take payments or receive income. Income tax deferral allowsyour money to potentially grow faster than in a taxable account, because earnings that otherwise would be subject to taxes are available for growth. Then as income is needed this huge benefit of ‘exclusion’ applies. It’s a double tax benefit – income tax exclusion & income tax deferral. Remember the exclusion benefit applies to non-qualified money only. Income from qualified money within the split annuity is fully taxable. Exclusion applies to non-qualified money.

Another feature of the annuity arrangement rather qualified or non-qualified is flexibility. The fixed-interest deferred annuity can provide a new income stream at its maturity. Also, most fixed-interest deferred annuities allow you to withdraw a portion of the annuity’s cash value without penalty. This option provides you with access to additional money should you need it in addition to the immediate annuity payments. At the end of the immediate annuity payout period, the fixed-interest deferred annuity is worth the original amount of your investment in both annuities. At that time, you can use the money from the fixed-interest deferred annuity however you wish, including another split annuity.

We use the split annuity arrangement for both qualified money and non-qualified money. There are tax benefits for either. Non-qualified money enjoys greater tax treatment. Split annuity arrangements – properly arranged – provide for continuation of income for lifetime.

Richard J. Schillig, CLU, ChFC, LUTCF is an Independent Insurance and Financial Advisor with RJS and Associates, Inc. He can be reached at (563) 332-2200.