income tax bracket – Retirement Income Center

2014 marked the introduction of qualified longevity annuity contracts, or QLACs. For those of you not familiar with them, a QLAC is a deferred fixed income annuity designed for use in retirement plans such as 401(k) plans and traditional IRAs (a) that’s limited to an investment of the lesser of $125,000 or 25% of the value of a retirement plan and (b) requires that lifetime distributions begin at a specified date no later than age 85. QLAC investment options are currently limited to deferred income annuities, or DIAs.

The purchase of deferred fixed income annuities in retirement plans for longevity protection isn’t a new concept. What’s unique about QLACs is the ability to extend the start date of required minimum distributions (RMDs) from April 1^st of the year following the year that you turn 70-1/2 to up to age 85. This provides potential income tax planning opportunities for QLAC holders subject to the purchase cap.

Potential Income Tax Savings

A lot of individuals are selling QLACs short due to the purchase cap. While on the surface, $125,000 may not represent a sizable portion of a retirement plan with assets of $750,000 or more, the potential lifetime income tax savings can be significant.

The amount of savings is dependent on six factors: (a) amount of QLAC investment (b) age at which QLAC investment is made, (c) deferral period from date of QLAC purchase until income start date, (d) rate of return, (e) income tax bracket, and (f) longevity.

Illustration

I have prepared the attached exhibit to illustrate potential income tax savings achievable by investing $125,000 at three different ages in a QLAC by comparing it to a non-QLAC investment that’s subject to the RMD rules. Assumptions used in the preparation of the exhibit are as follows:

$125,000 is invested in a non-QLAC vehicle at one of three different ages: 55, 60, or 65.
Rate of return is 5%.
RMD’s are taken from age 71 through 85, the range of ages between which RMD’s and QLAC distributions, respectively, are required to begin.
Income tax brackets are 2015 federal income tax brackets plus 5% for assumed state income tax.

In addition to assumed rates of return and income tax brackets, a key assumption is the age at which the QLAC investment is made. All else being equal, purchases at earlier ages avoid greater amounts of RMDs and associated income tax liability. Per the exhibit, the amount of projected income tax savings over 15 years ranges from approximately $20,000 to $97,000 depending upon assumed QLAC investment date and income tax bracket.

Considerations

Reduction of RMDs and associated income tax liability is an important goal, however, it may not be the best strategy for achieving the overriding goal of retirement income planning, i.e., making sure that you have sufficient income to meet your projected expenses for the duration of your retirement.

There are several questions you need to answer to determine the amount, if any, that you should invest in a QLAC:

What are your projected federal and state income tax brackets between age 71 and 85?
What are the projected rates of return on your retirement funds between 71 and 85 taking into consideration the likelihood of at least one bear market during this time?
What is your, and your spouse, if married, projected life expectancy?
Which years between age 71 and 85 can you afford to forego receipt of projected net RMD income, i.e., RMD less associated income tax liability?
Will you need to take retirement plan distributions in excess of your RMDs, and, if so, in which years and in what amounts?
What other sources of income do you have to replace the projected RMD income you won’t be receiving?
What is the projected income tax liability you will incur from withdrawing funds from other sources of income?
What is the amount of annual lifetime income that you will receive from a QLAC beginning at various ages between 71 and 85 assuming various investment amounts, with and without a death benefit with various payout options?
Does it make more sense to invest in a non-QLAC longevity annuity such as a fixed index annuity with an income rider?
Should you do a Roth IRA conversion instead?

Given the fact that opportunities to reduce RMDs and associated income tax liability are limited, QLACs are an attractive alternative. Projected income tax savings are just one factor to consider and can vary significantly from situation to situation, depending upon assumptions used. There are a number of other considerations that need to be analyzed before purchasing a QLAC to determine the best strategies for optimizing your retirement income.

The 2013 Tax Law Schizophrenic Definition of Income – Part 2 of 2

Per last week’s blog, as a result of President Obama’s signing on January 2nd of the American Taxpayer Relief Act of 2012 following changes legislated by the 2010 Health Care Reform Act effective beginning in 2013, there are now five different definitions of income affecting seven different tax areas. Exhibit 1, which was also included in last week’s post, summarizes 2013 individual federal income-based tax law changes, comparing each one with the law in effect in 2012.

Please see last week’s post for a discussion of the first three definitions of income. This week’s post examines the last two.

Adjusted Gross Income Exceeding $250,000 or $300,000

Once your adjusted gross income (AGI) exceeds $250,000 if single or $300,000 if married filing jointly, your income tax liability will increase as a result of two affected tax areas: (1) Itemized deductions limitation and (2) Personal exemption phaseout. Although neither of these provisions was effective in 2012, both have been part of prior years’ tax law.

Itemized Deductions Limitation

The limitation on itemized deductions, known as Pease after the congressman who helped create it, was originally part of the Economic Growth and Tax Relief Reconciliation Act of 2001, was phased out beginning in 2006, and was repealed in 2010.

Back in 2013, the itemized deductions limitation reduces most otherwise allowable itemized deductions by 3% of the amount by which AGI exceeds the specified threshold of $250,000 or $300,000, depending upon whether you’re filing as a single or married filing joint taxpayer. Itemized deductions can’t be reduced by more than 80%. In addition, the reduction doesn’t apply to deductions for medical expenses, investment interest, casualty and theft losses, and gambling losses.

Personal Exemption Phaseout

The personal exemption phaseout is another reincarnation of prior tax legislation. Since 1990, the personal exemption has been phased out at higher income levels. The 2001 tax act phased out the phaseout beginning in 2006 with repeal in 2010.

Back in 2013, 2% of the personal exemption amount, projected to be $3,900, is eliminated for each $2,500 of AGI in excess of $250,000 for single filers and $300,000 for those using married filing joint tax filing status.

Taxable Income Exceeding $400,000 or $450,000

Welcome to 2013 tax law income definition #5 affecting two more income tax areas. If your taxable income exceeds $400,000 if single or $450,000 if married filing jointly, your income tax liability will be further increased by two different tax provisions: (1) Income tax bracket and (2) Long-term capital gains and qualified dividends.

Income Tax Bracket

The top tax bracket of 35%, which was in effect from 2003 through 2012, jumps by 4.6% to 39.6% beginning in 2013 for those individuals whose taxable income exceeds the single and married filing joint thresholds of $400,000 or $450,000, respectively. The last time that the 39.6% rate was part of the tax law and was also the top tax rate was in 2000.

Long-Term Capital Gains and Qualified Dividends

Beginning in 1982, tax rate reductions reduced the tax rate on long-term capital gains, i.e., capital gain income from assets held longer than one year, from 28% to a maximum of 20%. The rate was further reduced from 20% to 15% beginning in 2003 and also began applying to qualified dividends.

The 20% maximum rate on long-term capital gains and qualified dividends has returned in 2013 for those individuals whose taxable income exceeds the $400,000 or $450,000 threshold depending upon filing status.

Summary

With the exception of the Medicare Earned Income Tax and Medicare Investment Income Tax discussed in last week’s post, the other five affected tax areas resulting in higher federal income taxes in 2013 are reincarnations of prior tax law. Everyone with employment or self-employment income of any amount with limited exception will pay more tax in 2013 than they did in 2012, all else being equal. In addition, income tax liability will increase for anyone with certain types of income exceeding specified thresholds starting at $200,000 or $250,000 depending upon filing status. The cumulative effect of the various changes and associated increase in federal income tax liability will be significant for many people.