Next January a large SEP-IRA tax-sheltered retirement plan I manage begins its required minimum distributions (RMD). IRA's of all types are really annuities in a generic sense once they begin distributions. But there are at least two different ways of distributing annuities which are permissible under the US tax code: one is to take the cash value of the IRA and purchase an immediate annuity, and the other way is to keep investments in the IRA but distribute them on an approved actuarial basis. (I won't discuss variable annuities based on the dedicated earnings of mutual funds.)

It's best to think of immediate annuities as defined pension pension benefits, much like traditional pensions from large corporations, government, and labor unions. Depending on the existing long term bond interest rate and your age and sex, you will get a defined monthly payment (or quarterly if you prefer) for the rest of your life whether that is 5 or 25 years. Currently for a male aged 65 you can get about $1000 per month per $150,000 invested right now in an immediate annuity. You cannot outlive your annuity, and it protects you against a long term decline in interest rates.

One disadvantage is that your heirs will get nothing if you buy a straight one-life annuity. It's only good for your life. For married couples one would normally buy a joint life annuity, and there are various options for the survivor to get 100% of your monthly payment or 75%, 66%, or 50%. You get a larger monthly amount up front if your included heir gets a smaller percentage. If you have a separate insurance policy naming that same heir as beneficiary, and it could be converted to an annuity if you pre-decease that heir, you could lower the percent of the survivor benefit in the annuity and gain a larger monthly pay out. If you buy any immediate annuity from an IRA, the total payment is taxable income, whereas if you buy one with after tax dollars, only about 40% (currently) would be taxable with 60% being return of capital.

The advantage of the annuity then is the certainty of monthly payment which is a good thing for budgeting. Two disadvantages are that, excepting your spouse, your heirs will not inherit your IRA, and you have no inflation protection. Actually, for a reduction in your monthly pay out you can get either CPI-related protection or a fixed annual increase in your monthly payment. With regard to losing the ability to pass your IRA on if it's annuitized, leaving an IRA to non-spouses is fraught with many difficulties and taxes that make them not very good bequests compared to leaving a non-spouse an after tax bequest.

Nevertheless, it's not a bad idea to look at the numbers and consider the management costs and time costs of continuing to manage your IRA during retirement. At current rates, mentioned above, $600,000 for an immediate annuity at age 65 will get you about $4000 per month for life. You'd have to earn each and every year 7% on that $600,000 to beat the annuity pay out. That might sound easy after 20 years we've had of generally rising stock and bond prices, but we don't know the future of the markets, and we can't take a lot of risk if we're running our own investment program in retirement.

If you do want to run your own retirement program during your retirement, or have someone run it for you, you are essentially doing the other type of annuity. The required minimum distributions (RMD's) mandated by the IRS beginning at age 70/71 are based on an actuarial table, and you must take out an increasing amount each year as you have one less year of total life expectation. The first table shows what the RMD's would be for a $600,000 IRA earning 7% per year every year. As you can see the first year RMD pay out is less than one-half the $4000 from a $600,000 immediate annuity! It would take ten years to get up to $4000 per month. The advantage is that your payment will increase every year assuming you make at least 7% every year. So this approach is somewhat like buying the inflation adjustment for an immediate annuity: a lower starting amount which gradually increases to help neutralize inflation. You could of course take out $4000 per month from your IRA starting at age 70/71, and assuming you make 7% or more a year, it would last you to age 95, as shown in the second table. But then it is your risk to make 7% whereas with the immediate annuity it is the insurance company's risk.

Currently a $600,000 immediate annuity for a 70 year old married male with a 100% spousal survivorship benefit and a 3% per year increase in payments would get you $2889.05 per month or $34,669 for the first year starting September 1, 2007.

If I have been clear and understood, I believe you can see the basic issues and trade-offs for "harvesting" one's retirement funds during retirement. The risk to investing the IRA yourself is whether you can make 7% each year. Some years it could be far more, some it will be less, and some years you could lose money. Keep in mind also that your balance will start to decline at some point depending on your rate of return and that you must take out the RMD even if you haven't earned it that year.

Visit Hugh Chou's website and play with the numbers in his IRA RMD calculator which is simple and excellent and from which my examples come: http://www.hughchou.org/calc/irawith.cgi

If anyone had told me ten or fifteen years ago that I would have any interest in annuities, I would have laughed loudly. I am not an annuity salesman nor do I get any benefit from anyone having to do with annuities in any way. I only manage my own money and that of immediate and extended family members. In this article I am describing my own thought processes and study on the question because of the large SEP IRA which will need RMD's to start next year. The owner of that IRA received an unanticipated bequest with which she is going to buy an immediate annuity (only 40% of the pay out will be taxable) and will probably maintain the IRA and take only the RMD's each year. There are many ways to structure retirement draw downs, and this is just one way.

The larger and retail-orientated low cost mutual fund companies such as T. Rowe Price, Fidelity, and Vanguard do sell annuities at much better prices and pay outs than you will get from an insurance agent or general annuity seller. I have looked at quotes which you can get with no commitment at Vanguard's site: http://www.aigretirementgold.com/vlip/VLIPController?page=RequestaQuote

Several caveats: you do not need to purchase an immediate annuity all at once. You could buy one with a part of your funds and wait until later and perhaps buy another one or more if interest rates go up. the older you are when you buy an annuity the higher your payment, and the higher the interest rate the higher your payment. And regrettably, some US states charge a 1-3% tax on the purchase of an annuity, so check out your state of residence.

Soon I will describe here some portfolio changes I have made which make funds I manage for people near retirement more suitable and less risky.

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