Lesson #6
How Annuities Can Potentially Reduce Taxes
7 Annuity Strategies of The Wealthy
This lesson offers practical planning techniques that can potentially increase your income
and reduce your taxes at the same time with annuities!
(You could even lower or eliminate taxes on your Social Security or other retirement income sources.)
Benefit #1 – Tax-Deferred Growth
A primary advantage of deferred fixed annuities is the opportunity to accumulate money as your premium and interest grow tax-deferred. Until you choose to make a withdrawal, the earned interest rate on a privately owned annuity is not currently taxable by the federal or state government .
In contrast, with other, taxable financial vehicles, a 5% return rate could become an actual return of only 3.6% if you are in a combined 28% tax bracket. Once you factor in inflation, you can see how difficult it could be to get your money working for you the way you want!
Deferred fixed annuities, however, can provide you with a triple compounding interest environment! With annuities , you not only earn interest on your principal and your interest, you also earn interest on what you would normally pay in taxes. You will not pay income taxes on your annuity interest until you withdraw it from your annuity. This way, you control when you pay income taxes!
You may have noticed the similarity between deferred annuities and IRA accounts as both accumulate on a tax-deferred basis, but with a non-IRA deferred annuity, there is no limit to how much you can contribute. This is a distinct advantage!
IRAs limit you to a maximum deposit of only $8,000 per year, but with an annuity, you can deposit $8,000, $80,000, or even $800,000 in a single calendar year! Then you immediately begin earning tax-deferred interest on that deposit.
Benefit #2 – Annuity "Exclusion Ratio"
In many cases, when someone “annuitizes” an annuity, which is simply converting a deferred annuity into a pension-style income stream, a sizable amount of that monthly income is delivered to the annuity owner tax-free.
Annuitized annuity monthly cash flow represents a simultaneous payout of a percentage of both taxable interest AND tax-free principal to the annuity owner. This is known as an annuity “exclusion ratio.”
Here is the IRS tax code definition of Exclusion Ratio:
If payment under an annuity is payable at regular intervals over a period of more than a year from the starting date (P1371) (Reg 1.72-2B) all or part of it may be tax-free which is a return of principal. Excess is fully taxable. (Internal Revenue Code SEC 72-b-1, Reg 1.72-4-A)
Remember Robert? Our fictitious example retiree?
If Robert attempted to generate retirement income by investing his $100,000 principal in a bond or CD and live off the interest, 100% of that interest would show up on his tax return each year, taxable at his normal income tax bracket. Robert's $100,000 principal investment generating 5% interest may create a BEFORE-tax income of $5,000, but after applying his 28% marginal tax rate, his spendable left-over income is only $3,600 or $300 per month.
If Robert were to take the same $100,000 principal, however, and annuitize it through a fixed annuity, it could generate as much as $625 per month of before-tax income. His exclusion ratio may be as high as 85%-90%, so up to 90% (or $562 per month) of Robert's retirement income would be completely tax-free, because the IRS views it as a return of his principal.
If you were depositing that same $100,000, and you could choose between $5,000 showing up on your tax return resulting in only $300 per month of spendable income, or only $750 showing up on your tax return resulting in $607 per month of spendable income – which would you choose?
But wait! There's more!
A secondary benefit is that you are hypothetically wiping $5,000 per year of taxable interest income off your tax return while saving taxes on the income received from your $100,000 principal, thereby potentially lowering your taxes on your other sources of retirement income!
Check out our next benefit.
Benefit #3 – Potential Positive Impact On Social Security Income
With all the knowledge you have gained, you are now effectively keeping a substantial amount of taxable interest income from showing up on your tax return each year whether you purchase a deferred fixed annuity accumulating interest on a tax-deferred basis, or you invest in an annuitized annuity that is paying out income according to the “exclusion ratio” benefit in the last section.
How does this relate to your Social Security income?
You should know that if your total household income exceeds certain thresholds, the IRS will impose additional taxes on your SS benefits. Here is how it works:
For a married couple filing jointly, the SS taxability threshold currently begins at $32,000 of combined household income. Taxes increase once your total household income exceeds $44,000.
Calculate this by taking 50% of your SS income. Now add your pensions, rents collected, investment interest/income, etc.
If that total sum exceeds $32,000, 50% of your Social Security income will have to be reported as taxable income and will be taxed at your current bracket.
If, after you calculate this, your total is over $44,000 of household income, up to 80% of your SS benefits may be taxed a second time. It can feel as though you’re being penalized for having a decent amount of income in retirement!
Now, suppose you run the calculations and end up just over $44,000 per year of combined household income, BUT $13,000 of that total income is coming from the taxable interest generated by your bond or CD investment portfolio. If you transfer some (or all) of that portfolio’s principal into a fixed annuity, you could increase the amount of spendable monthly income generated from that principal, while reducing (or even completely eliminating) the taxes due on your Social Security income!
This is just one example of how the tax benefits of a fixed annuity can be used in a real-life planning scenario to favorably impact your taxes in retirement.
As with any investment strategy, we recommend you discuss your situation with a credible, licensed tax professional before making any investment decisions. We are here for any questions you may have, and you can schedule a call at your convenience via the link below.
