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Making the right decisions at retirement: four tax and financial planning pointers.

The years immediately before and after retirement pose some interesting tax and financial planning opportunities for both planners and clients. This month, Kenn B. Tacchino, director of the Tax Institute, Widener University, Chester, Pennsylvania, and Barton C. Francis, CPA, CFP, partner of Shellenhamer & Co., Palmyra, Pennsylvania, describe some options financial planners must address to ensure clients a financially secure retirement.


Clients planning to take annuity distributions from a qualified retirement plan have two important decisions to make. The first is familiar to most CPAs--what type of annuity best suits the client's needs. The second decision--which annuity carrier to choose--often is overlooked.

Planners and clients may assume wrongfully the client is stuck with the annuity company sponsoring the plan. If, however, the plan provides a lump sum distribution option, CPAs can help clients shop for an annuity from another company.

The process is relatively simple. First, quotes should be obtained for the type of annuity the client has chosen. If an outside carrier provides a larger monthly benefit, all that needs to be done is to roll the client's account balance into an individual retirement account funded by the new carrier's annuity.

Since a rollover is being used, the tax consequences will not be any different than they would have been had the plan annuity been elected. What's more, this technique gives the planner an opportunity to shop for the most stable and secure annuity provider, which has added importance in today's environment of failing insurance companies.


Employer-provided qualified plans typically stipulate the type of distribution a client will receive. The normal form of benefit for a married individual is a joint and survivor annuity of not less than 50% nor greater than 100%. One strategy for married individuals is to elect out of the normal joint and survivor benefit with the spouse's written consent.

This election to have benefits paid as a life annuity increases the individual's retirement income significantly. If at the same time life insurance is purchased (or kept in force) on the life annuitant, the spouse's future also remains secure. This makes sense if net disposable income after the insurance cost is greater than the joint and survivor annuity option.

If the spouse dies first, the insurance can be canceled, leaving the retiree with more disposable income. If cash value life insurance is used, additional funds also may accumulate.

Example: Joe Jones (age 65) and his wife Sally (age 62) are eligible to receive a $1,500 benefit based on the $200,000 in Joe's retirement plan (100% joint and survivor annuity). If they elect to receive a life annuity based on Joe's life, they will receive $325 more each month ($1,825 total). The extra $3,900 a year represents a 22% increase in annual income.

If the Joneses can purchase (or keep in force) life insurance on Joe that would provide a death benefit equal to the purchase price of a life annuity comparable to the survivor annuity for Sally for anything less than $3,900 a year, they will increase their retirement income and improve their financial security.

Before this planning technique is adopted, it is imperative clients understand the potential weaknesses. If the pension plan makes cost-of-living increases or if the employer occasionally makes ad hoc increases, a much larger amount of life insurance may be required to provide the survivor with a similar income.

If universal life insurance or a vanishing premium are part of the proposed (or existing) insurance, the policy may not be adequate if interest rates fall as they have in recent years. The principal required to purchase a comparable annuity for the survivor will be much greater during periods of low interest rates.

Another consideration is whether survivor health insurance benefits are based on continuing participation in the pension plan. Finally, if the client fails to pay the insurance premium or the couple becomes estranged, the survivor's economic benefits may be lost.


As a general rule, annuity benefits paid from qualified plans are fully taxable. If, however, some of the annuity is attributable to contributions made with aftertax dollars (for example, nondeductible contributions ), the portion attributable to these amounts will not be taxed twice.

To distinguish between the tax attributable to pre- and aftertax contributions, an exclusion ratio must be calculated. Until recently, there was only one way to calculate this ratio. But an often overlooked rule change allows an alternative safe harbor method for determining the excludable amount. In most cases, the safe harbor method provides more favorable results.

Under the conventional exclusion ratio rules, the taxable (and nontaxable) portions of an annuity distribution are determined as follows:
Conventional Aftertax contributions
exclusion = annual benefit x life
ratio expectancy from Treasury
 regulations section 1.72-9

Under the new safe harbor method, the distributee recovers his or her investment in the annuity contract in level amounts over the number of monthly payments determined in exhibit 1, at left.

Example: Mary Hunter is scheduled to receive $12,000 per year from her retirement plan paid in the form of a 100% joint and survivor annuity. Mary and her husband, John, are both age 61 and have a joint life expectancy of 28.7 years according to Internal Revenue Service tables. Mary has made aftertax plan contributions of $34,440. Mary's exclusion ratio using the conventional formula is:
Exclusion $34,440(after tax contributions)=.l0
ratio = $12,000 annual benefits X
 28.7 year life expectancy

When Mary receives her monthly benefit of $1,000, she does not have to pay taxes on $100 ($1,000 x .1) and is taxed only on the remaining $900.

If, however, Mary elects to use the safe harbor method for computing the exclusion amount, she will be able to exclude $43.50 more than by using the conventional exclusion ratio method.

Exhibit 1 shows the number of months (240) used to compute the exclusion amount for a 61-year-old. Since Mary's investment in the contract is $34,440, the amount excluded from each payment is $143.50 ($34,440 + 240). By using this method, Mary pays tax on only $856.50, rather than on $900.


The conventional wisdom is retirees should make conservative, income-oriented investments. Retirees often shun growth-oriented investments such as common stocks and equity mutual funds and select so-called secure investments such as certificates of deposit and U.S. Treasury bonds. CPAs must help clients protect assets against loss of purchasing power due to inflation's long-term effects while generating sufficient income to meet current needs. With average life expectancies at age 65 of 13 years for men and 17 years for women, retirement could extend 30 years or more.

The only investment strategy with a good chance of beating inflation over the long term is investing a portion of the retirement portfolio in assets with growth potential, such as stocks. By combining the stability of fixed-income investments with growth investments, the impact of the volatility inherent in equities is minimized over the long term.

The Ibbotson data in exhibit 2, page 136, provide only the geometric mean or compounded annual return on certain investments. The deviation in returns for common stocks due to the market's inherent volatility prevents precise computations of short-term income and appreciation returns. Although stock prices are not perfectly correlated with cost-of-living increases over short periods, usually has exceeded inflation over periods of 10 or more years. In contrast, although the yields paid on bonds and similar fixed-income investments sometimes may look very attractive when compared to the dividend yields on stocks, inflation erodes the capital value of fixed-income instruments. Historically, the long-term return on interest-sensitive investments is only slightly greater than the rate of inflation and is much less than the longterm return on stocks. Although stocks are considered "riskier" than fixed-income investments in the short term, they are safer over longterm investment horizons of 10 years or longer. Example: A client invests $1,000,000 in 5% 30-year bonds, and the average annual inflation rate is 3.1%. The real yield at the time of investment is $50,000. After 10 years, the face amount of the certificate is $736,908 in original dollars, and the real yield in original dollars is reduced to $36,845. After 20 years, the certificate's purchasing power is reduced to $543,034 and the real yield to $27,152. At year 30, the purchasing power is $400,166 and the real yield is only $20,008. If the investor instead chooses to purchase only $500,000 of bonds and invests the remainder in common real yield on the portfolio in the first year averages $48,500. After 10 years, the purchasing power of all investments in original dollars is $1,025,552, and the real yield in original dollars is $49,307. After 20 years, the investments' purchasing power is $1,090,829 and the real yield $52,083. At the end of 30 years, the purchasing power is approximately $1,221,655 and the real yield $58,018. The growth in value of the common stocks and the dividend income hedges the loss in the bonds' purchasing power.


After a lifetime of working and saving, Americans face many important financial decisions. Astute CPAs recognize the opportunities created by demographic trends and position themselves, through education and marketing, to reap the economic and professional benefits of doing retirement planning. The planner's role involves more than analyzing the tax effects of qualified plan distribution options. Most clients need help developing realistic retirement goals and evaluating distribution and investment options. By adding the necessary objectivity and expertise, CPAs can help clients retire to something, not just from something.


* RETIRING CLIENTS face some important decisions that effect their long-term financial security.

* THE CLIENT DOES not have to elect the annuity offered by the company sponsoring the retirement plan and instead can shop for a carrier offering the largest monthly annuity benefit.

* A JOINT AND SURVIVOR annuity does not always provide maximum retirement income. A single-life annuity, with part of the increased benefit used to purchase life insurance, may significantly increase retirement income while still protecting the spouse.

* WHEN PART OF AN annuity benefit represents a return of aftertax contributions, an alternative safe harbor method can be used to determine the excludable amount.

* GROWTH-ORIENTED vehicles such as common stocks or equity mutual funds protect a portfolio against inflation.


Number of months for safe harbor exclusion method
Age of distributee Number of monthly payments
55 and under 300
56-60 260
61-65 240
66-70 170
71 and over 120

Under the new table, the "exclusion ratio" fraction changes to Aftertax contributions Tax-free portion Number of monthly payments of monthly annuity

 Summary statistics of annual returns, 1926-1991
Description Geometric mean
 Common stocks
total returns 10.4%
Income 4.7
Capital appreciation 5.4
 Long-term government bonds
Total returns 4.8
Income 5.0
Capital appreciation 0.4
 Inflation 3.1

Source: [copywrite] lbbotson Associates, Inc., Chicago
COPYRIGHT 1992 American Institute of CPA's
No portion of this article can be reproduced without the express written permission from the copyright holder.
Copyright 1992, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Francis, Barton C.
Publication:Journal of Accountancy
Date:Oct 1, 1992
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