John and Mary's monthly income from their employer sponsored defined benefit plans is based on single life values at age 55. When they reach age 57, they want to begin using the defined benefit plans. At age 57, John and Mary will have a total of $118,800 of income each year from their defined benefit plans. They will also have income form Mary's deferred compensation plan and if John sells his stock and reinvests in a diversified portfolio, they may have additional income from interest and dividends.
When they reach age 62, they could augment their income with $43,032/year from Social Security. These sources may or may not be enough to produce their goal of $250,000/year after retirement. If they need additional income, they will have to:
1. sell portfolio assets,
2. obtain cash from cash settlement of John's stock options,
3. withdraw from John's 401(k) plan, or
4. withdraw from Mary's IRA.
So what is the best order to draw from these accounts?
To the extent possible, taxable accounts should be used before tax-deferred accounts like IRAs or 401(k) plans. The assets in tax-deferred accounts generally grow faster than assets in taxable accounts so it is important to preserve them. Moreover, distributions from a tax-deferred account are taxed at ordinary income rates up to 35 percent, while the sale of capital assets produces tax at a maximum rate of 15 percent in 2012 (these rates are currently scheduled to increase in 2013).
The question then becomes whether John and Mary should withdraw first from their newly diversified portfolio or tap the profits from John's stock options.
Harvesting the stock options is the better choice for two reasons. First, John must exercise the options or lose substantial value. For example, assuming a 40 percent combined federal and state marginal tax bracket, the income after taxes from a cash exercise would be $108,000 in 2013 (0.6 x $180,000), $140,000 in 2014, $90,000 in 2015, $18,000 in 2016 and $144,000 in 2017. For most of these years, this is likely enough to bring John and Mary's income up to the desired level of $250,000. Second, John and Mary want to avoid holding a concentrated portfolio, so they would rather sell off ABC and XYZ stock than assets from their newly diversified portfolio, even if they didn't have to do so to take advantage of the options.
In either case, the nonqualified diversified investment portfolio will not only have tax issues but may require money management -- on an active basis, should they use nonqualified mutual funds. They may also spin off short-term gains as well as have management expenses. John and Mary might want to consider using a low-cost nonqualified annuity to avoid taxable transfer costs and get tax deferral potentially without surrender charges, depending on the contract.
Effective Uses Of Nonqualified Annuities In Retirement
Nonqualified annuities may also be very helpful for John and Mary. To guarantee the desired annual income of $250,000, they could purchase a joint and survivor income annuity to make up the difference. Given the possibility that John may have a shorter-than-average life expectancy, they may want to purchase an annuity for Mary's life instead.
Earlier we discussed the need to develop a diversified portfolio in the nonqualified area of their financial assets. One of the goals is to avoid taxes to the extent possible. That's one reason to use nonqualified assets first, by allowing qualified assets to grow tax-deferred before RMDs are required. The benefits of a nonqualified annuity include its tax deferral of gains and no RMDs. The biggest drawbacks typically are internal annuity charges as well as potential surrender charges.
Various types of annuities may help in this situation. Annuity contracts allow for tax deferral of growth not needed for income, and taxable income at the time of distribution. With a variable annuity, there may also be the ability to use managed accounts and take distributions without any withdrawal charges. In addition, there are fee-based annuities that have the ability to change subaccount allocations with no taxation or fees. Mary and John might consider those contracts to avoid the usual transfer of taxes that active management of nonqualified mutual fund or stock investments typically cause.
As you can see, there are a number of ideas you can use to help clients develop their retirement drawdown strategy. As a financial professional, you are the pilot, guiding your client's flight to retirement as calmly as possible. With a complex topic like retirement drawdown, it's important to work with other professionals, including attorneys, tax advisors, CPAs, etc., in a team environment to assist you in developing a creative strategy that may help your clients feel more comfortable in their retirement years.
Jim Johnson is vice president of Advanced Markets for Allianz Life Insurance Company of North America. Johnson is a frequent speaker on Advanced Markets topics and employs his extensive legal, advanced planning, life insurance and training expertise to help financial professionals achieve retirement-planning goals for their clients. Content for this article was developed in cooperation with Keebler & Associates LLP.