- The last two years have been marked by the highest inflation rates in decades; your clients saving for retirement can use this to their advantage through short-term investments, tax deferral, and insurance products offering better benefits.
- Fixed annuities can help your clients maximize those higher rates while also deferring taxes, allowing them to take advantage of potentially lower retirement tax rates in the future.
The last two years have been marked by the highest inflation rates in decades. This has caused the Federal Reserve to raise interest rates in an attempt to slow the rapid increase in consumer prices. The ripple effect of these rate hikes can be felt throughout the economy in the form of higher mortgage and consumer loan interest rates, potentially making things more expensive for people looking to buy a home or car. You can support your clients through inflation anxiety by helping them take advantage of higher interest rates.
It wasn’t that long ago that inflation was almost non-existent in the economy. From 2010 to 2020, inflation as measured by the Consumer Price Index averaged around 2 percent, a relatively low level by historical standards. This allowed the Federal Reserve to leave interest rates low. Unfortunately, however, interest rates offered by financial institutions to savers were also very low. From 2010-2019, the average interest rate on a one-year certificate of deposit was about .5%, never even topping 1%.1 This means that if your clients had savings in cash, they were likely still losing ground to inflation.
Some of your clients may have turned to bond funds as a way to generate more yield. The problem with bond funds, however, is that they can fall in value as interest rates rise. We’ve seen this over the last couple of years. In fact, 2022 was one of the worst years on record for a 60/40 stock/bond portfolio, largely due higher interest rates causing long term bond prices to fall.2 Some short-term investments, on the other hand, aren’t as sensitive to interest rates. Your clients can mitigate interest rate risk simply by holding them to maturity.
The good news for your clients saving for retirement is that these shorter-term investments are now offering some of the highest interest rates we’ve seen in years. Do a quick Google search and you’ll find multiple offers of annual percentage yield (“APY”) on certificates of deposit of more than 5%. While these rates still won’t completely make up for time lost to inflation, it’s still a good opportunity for savers with cash. It’s easy to get excited about higher interest rates on savings, but this also creates an issue that most people haven’t had to think about in a long time. Unless it’s held in a tax deferred retirement account, interest from a savings account, money market fund, or certificate of deposit is taxable as ordinary income in the year it’s received. This can mean an unexpected tax liability for the uninitiated. Taxes can also erode the value of the otherwise solid return you’re receiving.
Know your tax bracket
One thing I stress when I get to speak with retirement savers is that you always need to know your tax bracket. Your clients won’t be able to understand the after-tax value of an investment unless they do. For example, if they were to invest $100,000 in a certificate of deposit, and it pays them $5,000 in interest, they will have to pay taxes on the interest in the year they receive it. Let’s assume they’re a married filer with $250,000 of taxable income. This would put them in top marginal tax bracket of 24%, and this is the tax rate that will apply to their interest income. That would leave them with an after-tax return of $3,800 ($5,000 x 1-.24). Still better than five years ago, but maybe not quite as good as what they thought when they made the investment.
With this in mind, some clients might benefit by deferring that income to a year when they are no longer faced with a high marginal tax bracket. For many people, this might mean retirement. A fixed annuity can be a smart approach for those seeking a great rate of return now, while also deferring taxation into the future. Keep in mind that fixed annuities may require that they keep their money invested for a longer period (often 1, 3, 5, or 7 years) in order to get a desired rate.
When clients are invested in a fixed annuity, they won’t have to pay taxes on the gains in the contract until they withdraw money from the contract or surrender it. At maturity, a fixed annuity can be exchanged for a new contract via Internal Revenue Code Section 1035, further deferring taxation of the gains in the contract. This can be a very effective approach for clients who’re in a high tax bracket now but anticipates being in a lower bracket when they ultimately withdraw the gains from the contract.
Competitive Benefits on Products
Another way that higher interest rates can benefit clients saving for retirement is by allowing insurers to offer more competitive benefits on insurance products generally. From guaranteed lifetime withdrawal benefits on variable annuities, to cap rates on fixed indexed annuities and indexed life insurance products, to fixed and immediate annuity rates, higher interest rates allow insurance companies to offer consumers more attractive more competitive benefits on insurance products. These products may help retirees by meeting their investment goals with less risk, and in some cases, a smaller allocation of retirement assets.
Most financial planners recommend having up to six months of expenses set aside in a fully liquid emergency fund. For excess cash assets, however, taking advantage of higher interest rates is a great way to blunt the impact of inflation. Fixed annuities can help your clients maximize those higher rates while also deferring taxes, allowing them to take advantage of potentially lower retirement tax rates in the future. Finally, incorporating insurance products like annuities and permanent life insurance into your clients’ retirement portfolios can be another great way to benefit from a higher interest rate environment.