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tax matters

Tim Cestnick is president of WaterStreet Family Offices, and author of several tax and personal finance books.

I can recall when I was a child that I made a trip to Montreal with my mother to visit my great-great-grandmother. She was 104 years old. I remember my mother asking her: "Grandma, what's the best thing about being 104 years old?" My great-great-grandmother reflected for a few moments: "There are two things I enjoy." She began, as I listened carefully to every word she spoke. "First, I still like a good laugh, and second, I have no more peer pressure."

Getting older also comes with challenges. Many seniors are having to deal with consistently low yields on their fixed income investments. Yet, taking on more risk in the hope of higher returns is not the answer for most folks. Today, I want to revisit an idea that can provide higher after-tax yields than many traditional fixed income investments without increasing risk. I'm talking about an insured annuity.

The problem

Let's take Sam as an example. Sam is 65 years old and has $1-million of fixed income investments in his portfolio (even if you haven't got $1-million, this idea can work for you; I'm using a round number to make the math easy). Sam is earning 3.5 per cent on his fixed income investments, has a marginal tax rate of 45 per cent and is in good health.

Sam's portfolio will generate about $19,250 annually in after-tax income, or about $1,600 each month for him to meet his costs of living. By all accounts, this is not a large income on a portfolio of $1-million. Even worse, the income won't be indexed to inflation. Sam may have to start drawing down on his $1-million of capital if the $1,600 each month isn't enough for him. How much will his kids inherit? Who knows? (Some would say "who cares?") It depends on what happens to interest rates and how much he spends.

The idea

Suppose that Sam were to take the $1-million and invest it in a prescribed annuity. This annuity will pay out a fixed amount monthly for the balance of Sam's life. Now, each annuity payment is partly taxable interest income, and partly a return of Sam's original capital. In Sam's case, the annuity will generate annual gross income of about $78,000, of which $17,000 is taxable, resulting in after-tax annuity income for Sam of $70,350.

What a difference. This after-tax income is much higher than the $19,250 earned by Sam's current portfolio. What's not to like about this? Hey, before you jump to liquidate your fixed income portfolio to invest in an annuity it's important to understand some of the risks and side-effects.

The risks

This strategy will provide you with greater after-tax income, for sure. But what if you pass away? In Sam's current case, his kids will inherit the balance of the capital in his portfolio. But if Sam were to invest his $1-million in an annuity, the kids would inherit nothing (or perhaps very little if he purchased an annuity with a guaranteed payout upon death). To solve this problem, Sam should consider buying a life insurance policy to replace the $1-million of capital invested in the annuity. He can use some of his annuity income to pay for this policy.

A $1-million universal life insurance policy on Sam's life will cost approximately $30,000 annually. Sam could use his $70,350 of after-tax annuity income and pay the $30,000 life insurance premium each year. He'd still be left with $40,350 after tax annually (or about $3,360 each month). This is still much higher than the $19,250 (about $1,600 each month) provided by his current fixed income portfolio.

Another risk with a prescribed annuity is that Sam has given up liquidity. His current portfolio provides the ability to access all or part of his $1-million at any time. If he invests in the annuity, that capital is no longer available. He will have traded that liquidity for a certain income. You can manage this risk by not using all of your capital to purchase the annuity; perhaps you invest just a portion in this strategy.

A couple of final points to note: The level of your annuity payments will be affected by interest rates at the time you acquire the annuity (the idea can still make sense even in this low interest rate environment if you're content with the payments quoted today), and your annuity payments will never change (unless you opt for an inflation-adjusted payment) but your costs of living will likely rise over time.