Dear Rick:
My husband and I have been retired since the beginning of the year. His pension along with both of our Social Security more than covers all of our expenses. In fact, since the beginning of the year we still have been saving money. We do have a nice size portfolio that’s invested in mostly mutual funds between our IRAs and trust account. We believe we have more than enough money to last us the rest of our lives. My husband just received an inheritance of a little over $100,000. We have no debt; however, last year we agreed to pay off our granddaughter’s student loans. She owes a little over $90,000 and the interest rate is about 6½ percent. My thought is that we should use the inheritance and pay off the student loan. We have also been approached about taking that money and buying a fixed annuity. What that person told us is that we could take a distribution from the annuity every year and use that to pay the student loan. The salesperson told us in the long run we would be further ahead, and we would save on taxes. You should also know we are conservative investors and we no longer can itemize our deductions. My question – what do you think we should do?

Thank you.

Kim

Dear Kim:
I agree with you; I believe your best course of action would be to pay off the student loan. If you pay off the student loan you are getting a 6½ percent return on your money. This is an after-tax return considering your tax situation. In today’s world, a guaranteed 6½ percent return after taxes is a very good rate of return.

I do not see any benefit for you to purchase the annuity. First, the fixed annuity that you are talking about is not going to return 6½ percent after taxes; the return is going to be considerably less. In fact, your return will probably be closer to 3 – 4 percent, if not less and you have to pay tax on that money. Therefore, after taxes you’re only going to net 2 ½ to 3 percent. Therefore, in order to cover the payment, you’re going to have to start using some of your principal. In addition, because you would be taking out money on a year-by-year basis, there is no tax benefit whatsoever to the annuity. In fact, the only benefit I see for you to purchase the annuity is for the salesperson, who would receive a substantial commission.

When someone receives an inheritance or a bonus, paying down debt is a great use of that money. In fact, in many situations, I tell people paying down debt is much better than investing that money. The key is to look at the debt and see what it’s costing you after taxes. Particularly, for someone who is a conservative investor, if your after-tax cost of the debt is anything north of four percent, you probably should use the inheritance or bonus to pay off the debt. On the other hand, if someone is more of a moderate or aggressive investor, investing the money, particularly if you can invest for the long run, may be a good option. However, in almost no situation is it better to put money into an annuity versus paying off the debt. Remember, annuity salespeople like to tell you that annuities have great tax breaks, but that is not necessarily the case. With an annuity, if you don’t touch the money, it does grow tax deferred. However, eventually when the money is withdrawn, it is taxed to you at your ordinary income tax bracket, not the more favorable capital gain rate. Therefore, when you look at annuities, what the salespeople claim is a tax break may actually cost you more money in taxes in the future, because you are not eligible for the favorable capital gain treatment.

One last note regarding annuities – if you are thinking about an annuity, make sure you shop it around. Not only do rates of return differ amongst companies, but also other terms are different such as the penalty period and expenses. If your goal is like mine to have more money in your pocket, if you are thinking about an annuity make sure you shop it around with a number of different companies, because you will find by shopping around you’ll get better rates of return which means more money stays in your pocket, exactly where it belongs.

Good luck!

Rick is a fee-only financial advisor.  If you would like Rick to respond to your questions, please email him at Rick@bloomassetmanagement.com.
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