Thursday, October 22, 1998

Q. I am a 57-year-old federal employee and will be faced in five years with a retirement choice. Do I want 100 percent of my calculated annuity, or will I accept about 90 percent of it in exchange for the promise that my surviving non-working spouse (now 50) will receive 55 percent of it if I predecease her?

Having chosen survivor benefits, if she predeceased me I could receive the 100 percent annuity starting at the beginning of the subsequent year, but there would be no refund of the previously paid 10 percent premiums.

We have no debt and are both in excellent health.

In round dollars, the question is whether or not we should forgo $5,000 a year in exchange for a promise that my wife will receive $28,000 annually if I die. Would we be smarter to choose a 100 percent annuity and do something else with the extra annual $5,000 such as purchase whole or universal insurance on my life at the time I retire or otherwise invest it? All of these figures are subject to future annual cost of living adjustments. Many federal employees may be interested in the answer to this question.

—P.M., Dallas, TX

A. There is a life insurance technique called "pension maximization" which deals with this issue. Basically, you use a portion of your pension to buy a life insurance policy that will provide the survivor the income guaranteed by the pension. If the third party insurance policy costs less than the pension reduction, you have increased your immediate pension income and increased your financial flexibility. If your spouse dies before you do, the policy can be cashed in.

Thats the theory.

Unfortunately, the numbers don't work very often and the best course for most people is to take the pension reduction. It is particularly good for federal employees if your pension works as you describe because the reduction in your pension isnt permanent if your spouse dies. In private pensions the reduction is permanent.

The main impediments to "pension maximization" are income taxes and the rising cost of life insurance as you get older. You will forgo $5,000 of gross income but less in purchasing power. If you are in the 28 percent tax bracket, the after-tax cash available to buy a life policy would be about $3,600 a year. That wont buy a lot of cash value life insurance on the life of a 62-year-old man. Remember that it has to be enough life insurance to provide your wife with an annuity income of $28,000 a year and she will be only 55 when you retire.

The term insurance route doesnt work very well, either. While it could reduce the immediate premiums, they would rise over time. Eventually, you would not be able to afford the premium or would be ineligible for insurance, or both.

My advice: take care of your wifes security in a way that is simple, direct, guaranteed, and tax efficient— arrange for survivor benefits on your pension.

Q. Here is our situation. My husband and I are 63. I am retired and receive $1,800 a month in pension and $570 a month in Social Security. If he retires at age 65 he will receive about $1,000 a month in Social Security. He has no pension plan except for profit sharing that is included in his 401k plan. The plan is worth about $95,000 now and we hope it will be worth about $110,000 at retirement.

We owe $110,000 on our home (at 9 percent interest) and it is valued at about $130,000 with a loan payment of $1,400 a month.

Should we take out the full amount of the 401k plan at retirement and pay off the mortgage? Will this be added to all other income for the year and taxed?

—J.B., Chaska, MN

A. Withdrawals from qualified plans are taxable income in the year you make the withdrawal. There is no way around this. That means you would pay relatively high taxes if you took the money out in one step.

There are a number of actions you can take. Heres a list:

  • You could look into refinancing your mortgage down from 9 percent to something about 6.5 percent. That would lower your monthly payment.
  • You could take a close look at your expenses and make a real effort to pay down the mortgage as much as possible in the next few years.
  • Your husband could delay his retirement for a year or two. This would increase his Social Security income, allow the 401k plan to grow, and give you more time to reduce the mortgage.
  • You could consider selling the house and moving to an apartment or condo. Between a lower cost and lower operating expenses it would reduce your shelter expenses substantially.