Pension Income Planning: How Taxes, Life Insurance and Annuities Factor In

Finances are a primary cause of post-retirement stress, whether it’s the fear of leaving nothing behind for loved ones, or fear of exhausting assets before death. In both cases, planning can help. Pensions, life insurance and annuities are three financial instruments that many people use to secure their post-retirement life and leave financial stability behind for their family.

Here, we’ll consider these planning tools in depth, including how each one is taxed.

A Few Things to Consider When Selecting a Pension Plan

Pension plans are offered by employers, and they provide post-retirement payments to those who join the plan. They’ve been around for almost 150 years and remain a proven way to fund retirement. Most pensions pay out every month, but some plans offer a lump sum/monthly payment hybrid.

When an employee chooses a pension plan, they’re setting the financial parameters for retirement. It’s a big decision, in other words, and there are some important considerations. For example:

• Will survivor benefits be necessary? – The most pressing concern may be providing for a spouse or dependent children following death. Some pension plans offer survivor benefits, which means the pension continues paying out to the surviving spouse should the employee pass away first.

Some plans only pay out a portion of the full benefit to survivors, while others continue to make full payments to the surviving spouse. The downside? Compared to a plan with no survivor benefits, those with survivor benefits don’t pay out as much month over month.

For example, a plan may provide $2,000 a month with no survivor benefits, $1,600 a month with a 50 percent survivor benefit ($800), or $1,200 with full survivor benefits.

• Planning pension taxes – Pension income is fully taxable, whether it’s paid out to the employee or a surviving beneficiary. As such, some retirees combine their pension with other financial planning vehicles to offset their tax burden.

How to Leverage a Life Insurance Policy to Maximize Pension and Death Benefits

For many pensioners with loved ones to care for, it’s unconscionable to take a plan without survivor benefits. There’s more than one way, though, to provide death benefits to loved ones.

Life insurance is another standard end-of-life financial planning tool, and it can be combined with a pension plan to maximize pension payments and death benefits.

In this instance, the death benefits associated with the life insurance policy can replace the survivor benefits that would be provided by the pension. To do this, the surviving beneficiary would take the lump sum offered by the life insurance policy and invest it into an annuity.

With this approach, employees and their spouses can extract maximum value from the pension and the insurance policy. Because survivor benefits won’t be required through the pension, the maximum amount can be paid out every month, and then the life insurance policy – and an annuity – provide ongoing payments following the pensioner’s death.

Life insurance benefits also come with a tax bonus, as death benefits awarded by a life insurance policy are not taxable.

What Happens if the Employee’s Spouse Dies First?

If the employee’s spouse passes away first, and the employee has a pension and a life insurance policy in place, they still have plenty of options regarding what to do next. For example:

• The insurance policy can be cancelled, and any cash value returned to the employee
• The insurance policy can be passed to another beneficiary, like a child
• The insurance policy could be amended to stop or reduce premiums, in exchange for a reduced benefit amount

And these options are available even while the employee receives their full pension benefit (because death benefits were provided by the insurance policy).

How an Annuity Can Supplement Retirement Income

Annuities allow people to invest in a fund that is paid out in smaller increments over time. Annuities are considered a hedge against outliving the value of your assets, as they contain an income rider that ensures lifelong income – as long as the annuity is fully funded and enters the annuitization phase. At this point, fixed payments are provided as long as the employee remains alive. Payments consist of principal and interest – only the interest portion of the payment is taxable. The exact composition (principal vs. interest) of payments depends on the age of the recipient, how long the annuity has been active and the annuity’s provisions.

Terms and provisions vary greatly from annuity to annuity, and there are penalties attached to early withdrawals. They can be useful retirement planning tools, but annuities require careful consideration before choosing one.

Retirement Income Planning – the Risks Involved

There is a major upside involved with pensions and other retirement planning tools, but there’s risk, too. Some of them are difficult to identify beforehand, so here’s what to consider risk-wise before confirming any retirement planning options:

• Some pension plans only pay out a predetermined amount or for a predetermined amount of time. It’s essential for employees to know the difference between available plans.
• Most life insurance plans have incontestability clauses baked into their contract. Incontestability laws vary from state to state, but they generally allow insurance companies to dispute death benefits if the policy holder dies within two years of the policy’s start date. For those in poor health, a life insurance policy may be a gamble not worth the cost.
• Many life insurance policies terminate when the policyholder turns 100, with no benefits. This means premiums will have been paid into a plan that will no longer provide value. This is done to keep premiums low, and there are universal life insurance plans that provide coverage past 100 years old. These plans come with higher premiums.
• Receiving a pension while paying life insurance premiums comes with significant tax-related downside. That’s because pension payments are fully taxable and life insurance premiums are not tax-deductible. For example, if an employee’s pension pays out $2,000 a month, and they pay $400 a month in life insurance premiums, they only have $1,600 available, but are taxed on the whole $2,000.

Pension Income Planning Can Be Complicated, So Speak with Your Houston Tax Professional Before Proceeding

Retirement planning is a high stakes game. If it’s not executed just right, there’s a risk of outliving your assets or leaving nothing to loved ones.

Given the stakes involved, it’s important for people to consult with a trusted Houston tax professional before opting into any retirement planning tools. They can review available pension plans, life insurance policies, and annuities for their clients, while keeping those clients’ future income and taxes in mind. In doing so, Houston tax professionals can identify the most advantageous approach for future retirees to take.