This is the fourth and final part of our series discussing eight characteristics that are shared by fixed income annuity (“FIA”) income riders and Social Security. The first seven characteristics of a fixed index annuity income rider were addressed in Parts 1 through 3, with #8, income taxation, the topic of this week’s post.
There are three income taxation attributes that FIA income riders and Social Security have in common as follows:
- Limited income tax deduction for investment funding
- Tax-deferred growth
- Benefits taxable as ordinary income
Limited Income Tax Deduction for Investment Funding
With qualified pension plans, e.g., 401(k) plans, there are pre-tax deductions available for employer and employee contributions up to specified limits. In the case of Social Security and FIA income riders, tax savings from initial and ongoing investment funding is limited.
For Social Security, the ability to take an income tax deduction is limited to employer contributions. Employee contributions are nondeductible. For 2012, employers may deduct their contributions of 6.2% of Social Security earnings up to a maximum of $110,100 per employee. Self-employed individuals may deduct the employer portion of Social Security and Medicare tax, with the limit being identical to the employer portion of employee Social Security earnings.
When it comes to FIA funding, income tax deductibility is determined by FIA location. Like most investments, FIA’s can be held in nonretirement and retirement investment accounts. Contributions to nonretirement investment accounts are non-deductible. Contributions to retirement investment accounts, on the other hand, may or may not be deductible, depending upon the type of investment account and other rules, a discussion of which is beyond the scope of this post.
An important advantage enjoyed by both Social Security and FIA income riders is tax-deferred growth. Simply stated, there’s no taxation until payments are received. With Social Security, tax-deferred growth happens behind the scenes. Unlike 401(k) plans and IRA’s where each participant has a separate account where tax-deferred growth can be tracked, this isn’t the case for Social Security recipients. Tax-deferred growth is instead transparent since there’s no direct correlation between employee and employer Social Security contributions and benefits that are ultimately paid.
Although tax-deferred growth doesn’t occur behind the scenes, it isn’t as straightforward as with other investments, including the FIA accumulation value, when it comes to a FIA income rider. Income withdrawals are calculated based on a separate income account value. Please see the April 2, 2012 post, How is Your Fixed Index Annuity’s Income Account Value Calculated? to learn more.
Benefits Taxable as Ordinary Income
When taxable, Social Security and FIA income rider benefits are both treated as ordinary income. This means that, unlike long-term capital gains which enjoy a favorable tax rate, benefits are taxed at one’s regular income tax rates. The rates range between 10% and 35% and are dependent upon filing status and amount of taxable income.
The taxation of Social Security is dependent upon the total of one’s other income, tax-exempt interest, and one-half of Social Security benefits compared to a specified threshold amount that’s different for single and married taxpayers. When the total exceeds the threshold amount and benefits are taxable, anywhere between 50% and 85% of benefits are taxable as ordinary income depending upon the amount of the excess of the total over the threshold amount.
The taxation of FIA income rider withdrawals is dependent upon FIA location. When held in qualified plans and non-Roth IRA’s, 100% of all withdrawals in excess of one’s basis are taxable as ordinary income. Withdrawals from Roth IRA accounts are nontaxable. If not annuitized, income withdrawals from nonretirement FIA’s are subject to “last-in first-out,” or “LIFO,” taxation. 100% of all withdrawals will be taxed until all interest is recovered with subsequent withdrawals received tax-free as a return of principal.
Robert Klein, CPA, PFS, CFP®, RICP®, CLTC® is the founder and president of Retirement Income Center in Newport Beach, California. Bob is also the sole proprietor of Robert Klein, CPA. Bob applies his unique background, experience, expertise, and specialization in tax-sensitive retirement income planning strategies to optimize the longevity of his clients’ after-tax retirement income and assets. He does this as an independent financial advisor using customized holistic planning solutions based on each client’s needs and personality.