IRAs, annuities, and life insurance -- comparison of death

[dh003i]

I replied in response to the comments made at this blog-thread on the drawbacks of IRAs. One of the listed cons was that there's no death-benefit. I noted that one can invest in an annuity within an IRA, but that I didn't think you could buy a life insurance policy within one (further research verified this). However, of course, annuities are expensive relative to mutual funds, as you're paying for the benefits.

Regarding annuities in a retirement plan, the only possible benefits I can think of are: (1) To guarantee an income stream from the retirement plan after retirement; (2) To provide a tax-advantaged death-benefit, should you die early, for the advantage of your spouse's saving for retirement. Specifically regarding #2, are (or can) death benefits from annuities within IRA's (be) kept within the IRA and treated as all other funds in the IRA?

Upon some further research, I went to a site describing a "time bomb" for the elderly hoping to pass on their money to their heirs, that is present in both annuities and traditional IRAs. Neither of these vehicles, unlike stocks and bonds, has a step-up basis feature upon your death. This, of course, isn't applicable to Roth IRAs.

So, curious, what's the analysis of those here on the effects of this? It seems to me that, to the extent that one can convert to a Roth, this isn't applicable. (and after 2010, there will be no income limitations on conversions).

Thoughts?

[Guest allancoleman]

I see no disadvantages or ' cons ' to IRAs . My wife has instructions in the event of my death to " rename " my IRA in her own name as soon as possible and to specificly name a designated beneficiary to that account . That way , the tax deferred treatment can pass on to her selected heirs with less difficulty .

Agree with you about Roths passing to heirs easier . Presently have over 22% of my retirement portfolios in Roths and hope to have all of my investment monies in Roths as my ' last money spent ' by doing more conversions and withdrawing all other deferred accounts first . RMD later will assist in that task .

See no advantages to annunities . Most are ' sold ' , expensive , and not the usual investment that independant investors figures is such a good deal or a ' no brainer ' that they just have to have one . Just my opinion of course .

[dh003i]

allancoleman,

Thanks for your reply. As for benefits of annuities, the only one I perceived was a life-insurance like option in your Roth, thus if you die, producing a huge payment, which would be tax-free. However, looking through annuities, I haven't seen one that offers a truly "life-insurnace-like" benefit; all they do is offer the maximum your investment ever was, your premium back, etc.

Regarding them being "expensive", I believe that they're expensive because of the benefits they provide. I tend to think the market is pretty efficient, so I think that they're probably price about right for the additional benefits (in terms of risk-reduction) they offer. The question is, do specific individuals need these benefits?

The Motley Fool had an interesting article discussing the possible drawback to a 401(k) or Traditional IRA, Don't Max Out Your 401(k). The summary argument comes from a paper by Kotlikoff, who argues that because of the lower capital gains tax rates, if you invest long term in a few stocks that reinvest or engage in share-repurchases (instead of paying out dividends), this will be more beneficial than investing the money in a 401(k) or Traditional IRA. The key assumption there is that you rarely, or never, sell the stocks and incur capital gains along the way. This is not always a realistic assumption, as noted in the follow-up article, Dont' Max Out Your 401(k): Part 2.

Right now, I'm working on an excel model for the benefits of Roth => Traditional conversion, and possibly incorporating MC simulation into it. After that, I'm going to create a model comparing 401(k) / Trad. IRA investments to regular account investment, with one input for the probability of selling (thus incurring a capital gain or capital loss) in any given year, to figure out how rarely you have to incur capital gains in order to come out ahead with a regular account vs. a 401k or Trad. IRA.

I copy below my response to someone who noted the drawbacks of Traditional IRAs (which also apply to 401(k)s for the most part). I tend to agree, but had qualifying considerations...

First, I'd note that I would never suggest anyone use a Traditional IRA over a Roth IRA. However, for many, certainly 401(k)'s are good ideas at least up to the point of employer-matching (thereafter maxing out Roth contribs, and then only after getting employer-match and maxing out Roth contribs, investing more in a 401(k)).

While some of the problems you pointed out with Traditional IRAs are indeed true, they need to be weighed against the benefits, none of which you are considering.

The benefit of an IRA -- or 401(k), 403(b) or 457 plan -- is that they defer taxes. This reduces you current taxable income, which is beneficial for several reasons: (1) More money available right now for whatever you may deem important, which may include additional investment; (2) Your lowered AGI may allow you additional tax benefits -- such as ability to contribute to a Roth IRA -- that wouldn't be available to you if you had a higher AGI; (3) The deferral of taxes on your money allows you money to grow at a faster compound rate, which over time, will be beneficial, even if the money is eventually taxed at a higher rate than the capital gains tax rate; (4) Particularly if you are paying more taxes now than you expect to pay when you retire, deferred tax plans make sense; (5) If your MAGI is below $100k, you can roll over a Traditional IRA to a Roth IRA, which results in tax-free (not deferred) gains thereafter.

Of course, I recommend (almost universally for people with long time-horizons) a Roth IRA over a Traditional IRA. However, one should of course first max out employer contributions in their 401(k); you can't pass up the opportunity to get that money at your employer's expense.

Now, in light of that, responding to your noted problems...

"1) Taxed at ordinary income tax rates"

Which, as I explained -- though not as beneficial as treatment of Roth gains, which aren't taxed -- can still be beneficial if either you are in a high tax-bracket currently, or have a long time-horizon, or a combination of the both. And moving away from Trad. IRAs to 401(k)'s, contributing there can be especially beneficial, as you can contribute much more to a 401(k). Furthermore, with 401(k)'s after you leave your current employer (or when retiring), you can rollover the amount to a Traditional IRA, which can then be converted to a Roth IRA (you'll have to pay taxes on the conversion, either out of taxable accounts or the IRA). You then get the benefits of a Roth IRA.

"2) Controlled by the government who can change the rules any time they need more money"

Granted. That's a risk investors have to analyze and consider themselves. It can be amelioriated by keeping an eye on the situation, and being ready to take pre-emptive action if you deem such is very likely. However, note, there are also risks of non "government controlled" things as well: firstly, they may be more controlled by the government in the future. Secondly, to some extent, they may already be conrolled, or reported (see earlier in this thread regarding gold dealers).

"3) Cannot claim losses inside qualified accounts"

No, you can't, because you deferred taxes on 401(k) or Traditional IRA contributions. However, the long-term benefits probably outweigh this. Besides, when talking about your retirement horizon, you shouldn't have the mentality of losing money year-after-year.

"4) Cannot withdraw and redeposit funds into an IRA"

No, not for Traditional IRAs. A consideration individuals need to decide.

"5) Promotes the use of Term Insurance"

Can you explain how Traditional IRAs (and presumeably 401(k)s) promote the use of term life insurnace?

"6) No self completion in the event of a permanent disability"

Do you mean here, that if you get disabled, contribs aren't made on behalf of you?

I suppose one could buy insurance for this sort of thing, if such exists, or make a special arrangement with an insurance company.

"7) No death benefits if die prematurely"

Correct. IRAs are tax-advantaged savings vehicles, not annuities or life-insurance plans. You can, however, hold an annuity within an IRA. However, annuities have high expenses, and they provide no additional tax-benefit inside an already tax-benefitted account. I don't think you can buy life insurance within an IRA or Roth IRA, but am not sure.

"8) When taxes rise due to babyboomer's retirement, will pay higher taxes at withdrawl than when deferred going into account."

A risk you have to decide upon. A few notes: (1) In 2006 and 2007, for those over 70.5, they can donate money directly to a charitable institution from their 401(k), avoiding taxes on it; (2) If your AGI is currently under 100k, you can rollover a 401(k) to a Trad. IRA when you change jobs or retire; you can then convert that to a Roth IRA, paying taxes on the conversion as income, and then reap the benefits of the Roth IRA; for 2008 and beyond, you can convert directly from a 401(k) to a Roth IRA; (3) For 2010 and beyoond, the income limitation on conversion will be eliminated.

"9) Taxes are not saved in qualified plans, only deferred."

True. And if you can't take the deferral, and have to characterize the contribution as qualified, it is much less beneficial.

"10) After age 55 or so, it makes no economic sense to contribute to qualified plans as it takes decades to get exponential growth on the money."

It is less beneficial the older you get, but that doesn't necessarily mean it isn't beneficial. It will depend on how high your taxes are at the time vs. how high you expect them to be when you retire, how long your time-horizon is, and if you will be able to convert to a Roth IRA for tax-free growth for a long time-horizon. I plan on living to 120, so at 55, I'll only be half dead. I think people should take that outlook: don't plan on dying early.

Hope this has been helpful.

[John G]

DH003 - I don't think generalized or theoretical posts are very useful. I have asked you before to narrow the focus of your posts and to not attempt to explain points where you have no experience or professional training.

With regard to the question of annuities, there was an earlier post that folks may want to read:

http://benefitslink.com/boards/index.php?showtopic=33594

Annuities are a hybrid product of the insurance industry. There is minimal competition across the industry - most insurance agents only represent their own affiliated products. The two main pitches are the death benefit and the income stream. Annuities tend to be expensive (both due to commissions and imbedded annual fees) and offer relatively low performance. The promised income stream can be duplicated in many ways using laddered CDs, bonds, income focused mutual funds and dividend paying stocks.