Tag: required minimum distribution

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Annuities Deferred Income Annuities Income Tax Planning Qualified Longevity Annuity Contract (QLAC)

Is a QLAC Right for You?

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 1st 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:

  1. $125,000 is invested in a non-QLAC vehicle at one of three different ages: 55, 60, or 65.
  2. Rate of return is 5%.
  3. 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.
  4. 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.

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Annuities Deferred Income Annuities Longevity Insurance Qualified Longevity Annuity Contract (QLAC)

QLACs are Here

Since the Treasury and IRS finalized a regulation in the beginning of July blessing the use of qualified longevity annuity contracts, or “QLAC’s,” a lot of people have been wondering when and where they can buy one. Per the last paragraph of my September 15th “Don’t Expect to See QLAC’s Soon” post, speculation was that product launch may begin in the fourth quarter of this year.

The mystery is now behind us. The first QLAC to hit the market was recently released by AIG through American General Life Insurance Co with its American Pathway deferred income annuity. AIG enjoys overall high ratings from independent ratings agencies, including A+, or strong, ratings from Standard & Poor’s and Fitch Ratings, A, or excellent, from A.M. Best Company, and A2, or good, from Moody’s Investors Service.

What’s Different about QLACs?

Subject to their current investment limitation of the lesser of $125,000 or 25% of one’s retirement plan balance, QLACs offer two distinct advantages over other investment vehicles for meeting part of a retiree’s income needs as follows:

  1. A portion of retirement assets exposed to stock market declines can be exchanged for a predictable sustainable lifetime income stream beginning at a specific date up to age 85.
  2. Can defer income taxation of a portion of retirement plan balances for up to 15 years with its exemption from the required minimum distribution, or “RMD,” rules, that otherwise require taking minimum distributions from retirement plans beginning by April 1st of the year following the year that you turn 70-1/2.

Predictable Sustainable Lifetime Income Stream

QLACs are a special type of deferred income annuity, or “DIA.” A DIA is an annuity from which annuitization begins at least 12 months after the date of purchase in exchange for a lump sum or series of periodic payments. The annuitization can be for a term certain or lifetime, depending upon the terms of the annuity contract.

Fixed income annuities, including lifetime DIAs, have previously been allowed to be included in retirement plans provided that payments (a) begin by April 1st of the year following the year that the owner turns 70-1/2 and (b) are structured so that they will be completed distributed over the life expectancies of the owner and the owner’s beneficiary.

QLACs extend the potential income start date of retirement plan assets allocated to them to age 85. In addition to predictable sustainable lifetime income, this enables individuals who have other sources of income to increase the amount of annual income that they will eventually receive from QLAC investments compared to non-QLAC DIAs held in retirement asset accounts.

Circumvent RMD Rules for a Portion of Retirement Plan Assets

Other than converting retirement plan assets to Roth IRAs which often triggers income tax liability at the time of conversion, there has been no other game in town for avoiding the RMD rules prior to QLAC’s. QLAC’s offer an opportunity to defer taxation on up to the lesser of $125,000 or 25% of one’s retirement plan balance at the time of investment.

Depending upon the timing of the QLAC investment and the income start date, the reduction in RMDs and potential income tax savings can be significant. Suppose that you’re 50 and your traditional IRA, which is your only retirement plan, has a value of $600,000. Let’s further assume that you invest $125,000 of your IRA in a QLAC with an income start date of 80.

Had you not invested $125,000 in a QLAC, assuming a 4% rate of return, this portion of your IRA would grow to $273,890 when you turn 70. The first year RMD for this value would be just under $10,000. The income tax savings from not withdrawing this amount of income from your IRA and potential greater amounts for the next ten years could be significant.

QLAC Market

With the release of AIG’s QLAC, the cat is out of the bag. Other insurance carriers are either in the process, or will soon be, requesting regulatory approval for their QLAC offerings. Per my September 15th post, it was, and still is, my personal opinion that widespread availability will not occur until well into 2015. Once this happens and consumers understand and appreciate the two distinct advantages that QLACs offer over other investment vehicles for meeting part of a retiree’s income needs, I believe that demand for this unique product will increase significantly.

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Roth IRA

5 Ways to Reduce Your Tax Liability Using Roth IRA Conversions

One of the most important financial goals for retirees is maximization of after-tax income. There are two ways to accomplish this: (a) maximize pre-tax income and (b) minimize income tax liability. A Roth IRA can go a long way toward helping you achieve the latter.

There are two ways to fund a Roth IRA: (a) annual contributions and (b) conversions. Annual contributions, in and of themselves, generally won’t result in a significant source of retirement income due to the relatively low limitation – currently $5,500 or $6,500 if you’re age 50 or older. In addition, eligibility to make Roth IRA contributions is limited to the extent that your income exceeds defined limits.

Roth IRA conversions, on the other hand, have the ability to generate substantial after-tax income while also reducing income tax liability for up to 20 to 30 years or more of retirement. Since income tax liability on the value of Roth IRA conversions will need to be paid, timing of conversions is key. See the May 10, 2010 post, Be on the Lookout for Roth IRA Conversion Opportunities, for a discussion of this topic.

There are five ways that you can potentially reduce your income tax liability and increase your after-tax income during your retirement years by doing Roth IRA conversions.

1. Never pay income tax on the growth of your Roth IRA

While you’re required to include the value of your IRA, 401(k) or other qualified plan assets that you convert to a Roth IRA in your taxable income in the year of conversion, 100% of the growth of your Roth IRA is excluded from taxation. This is true whether or not you ever take any distributions from your Roth IRA.

Individuals who did Roth IRA conversions in March, 2009 when the Dow dipped below 7,000 didn’t mind paying income tax on those conversions in retrospect given the fact that the Dow is currently hovering over 17,000 less than six years later. The income tax savings on the growth of the equity portion of their converted accounts over this period of time plus future potential growth is significant for those in this situation.

2. Roth IRA accounts aren’t subject to required minimum distribution rules

If you don’t do a Roth IRA conversion, 100% of the value of your traditional IRA, 401(k), and other qualified plan assets, including appreciation, will be subject to IRS’ required minimum distribution, or RMD, rules. These rules require you to take annual minimum distributions from your retirement plan accounts beginning by April 1st of the year following the year that you turn 70-1/2. 100% of distributions reduced by any allowable portion of nondeductible contributions are taxable.

As an example, suppose you were born on January 7, 1940 and you own a traditional IRA account with a value of $500,000 on December 31, 2013, you would be required to take a minimum distribution of $21,008.40 from your account by December 31, 2014 and include it in your 2014 taxable income. If instead you owned a Roth IRA account with the same value, you wouldn’t be required to take any distributions from your account.

3. Potentially reduce net investment income tax

The RMD rules sometimes force people to take distributions from their taxable IRA accounts that they don’t need. Often times, they transfer RMDs from their taxable IRA account to a nonretirement investment account and leave them there. For individuals with high levels of income, this can result in additional taxation as a result of subjecting the earnings on their nonretirement account to the net investment income tax of 3.8%. This isn’t an issue for Roth IRA account holders since the RMD rules don’t apply to them.

4. Roth IRA distributions aren’t included when calculating taxable Social Security benefits

The taxation of Social Security benefits is dependent upon your combined income and tax filing status. Combined income includes adjusted gross income, nontaxable interest, and 50% of Social Security benefits.

Single filers are subject to tax on 50% of their Social Security benefits for combined income between $25,000 and $34,000 and up to 85% of benefits when combined income exceeds $34,000. Married filing joint taxpayers are subject to tax on 50% of their Social Security benefits for combined income between $32,000 and $44,000 and up to 85% of benefits when combined income exceeds $44,000.

Roth IRA distributions aren’t included in adjusted gross income, therefore, they don’t affect taxation of Social Security benefits.

5. More opportunities for income tax bracket planning

For all taxpayers, taxable income is subject to seven different rates of tax ranging from 10% to 39.6% depending upon the amount of taxable income. Given the foregoing four potential ways of reducing taxable income and associated income tax liability, Roth IRA conversions can also reduce the income tax rates that are used to calculate income tax liability on other sources of income. This allows for more opportunities for income tax bracket planning to potentially further reduce income tax liability in one or more years.

Although it’s not income-tax related, one other potential benefit of Roth IRA conversions that shouldn’t be overlooked is their impact on the calculation of Medicare Part B premiums. Monthly Medicare Part B premiums currently range from $104.90 to $335.70 depending upon tax filing status and the amount of modified adjusted gross income from two years ago. Roth IRA distributions aren’t included in the calculation of adjusted gross income. As such, they don’t affect the amount of Medicare Part B premiums paid.

As you can see, assuming (a) you can get over the hurdle of prepaying a portion of your income tax liability when you do Roth IRA conversions and (b) you have sufficient nonretirement funds to pay the tax, this can create several tax reduction opportunities as well as a potential reduction of Medicare Part B premiums throughout your retirement years. These benefits, combined with the ability to eliminate taxation on the growth of Roth IRA accounts, can result in greater and longer-lasting after-tax retirement income compared to not doing any Roth IRA conversions.

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Deferred Income Annuities Longevity Insurance Qualified Longevity Annuity Contract (QLAC) Retirement Income Planning

Don’t Expect to See QLAC’s Soon

One of the most exciting retirement income planning opportunities since the elimination of the Roth IRA conversion income threshold in 2010 has been approved, however, it isn’t available yet for purchase.

For those of you who may not be familiar with the change in Roth IRA conversion eligibility rules, prior to 2010, only taxpayers with modified adjusted gross income of less than $100,000 were eligible to convert a traditional IRA to a Roth IRA. With the elimination of the income threshold, Roth IRA conversions have soared in popularity since anyone may convert part, or all, of his/her traditional IRA to a Roth IRA. See Year of the Conversion to learn more.

The most recent potential retirement income planning game-changer, qualified longevity annuity contracts, or “QLAC’s,” have received a fair amount of press since the Treasury and IRS finalized a regulation in the beginning of July blessing their use. I have personally written two other articles about them, beginning with 6 Ways a New Tax Law Benefits a Sustainable Retirement published July 25th in the RetireMentors section of MarketWatch and my August 4th Retirement Income Visions™ blog post, You Don’t Have to Wait Until 85 to Receive Your Annuity Payments.

What are QLAC’s?

QLAC’s came about in response to increasing life expectancies and the associated fear of outliving one’s assets. With the passage of IRS’ final regulation, retirement plan participants can now invest up to the lesser of $125,000 or 25% of their retirement plan balance in specially-designated deferred income annuities, or “DIA’s,” that provide that lifetime distributions begin at a specified date no later than age 85. Unlike single premium immediate annuities, or “SPIA’s,” that begin distributing their income immediately after investment, the start date for DIA income payments is deferred for at least 12 months after the date of purchase.

As discussed in my July 25th MarketWatch article, QLAC’s offer a new planning opportunity to longevitize your retirement in six different ways. While longevity is the driving force for QLAC’s, the income tax planning angle, which is the first possibility, has been attracting the lion’s share of media attention. Specifically, QLAC’s provide retirement plan participants with the ability to circumvent the required minimum distribution, or “RMD,” rules for a portion of their retirement plan assets. These rules require individuals to take annual minimum distributions from their retirement plans beginning by April 1st of the year following the year that they turn 70-1/2.

Where Do I Buy a QLAC?

I’ve had several people ask me recently, “Where do I buy a QLAC?” Unlike the Roth IRA conversion opportunity that expanded the availability of an existing planning strategy from a limited audience to anyone who owns a traditional IRA with the elimination of the $100,000 income barrier beginning on a specified date, i.e., January 1, 2010, the implementation of IRS’ QLAC regulation is much more complicated. This is resulting in an unknown introduction date for QLAC offerings.

There are several reasons for this, not the least of which is the nature of the product itself. First and foremost, although an existing product, i.e., a deferred income annuity, or “DIA,” will initially be used as the funding mechanism for QLAC’s, the contracts for DIA’s that are currently available don’t necessarily comply with all of the various provisions of IRS’ new QLAC regulation. While the three mentioned are the most important, i.e., (1) Only available for use in retirement plans, (2) limitation of lesser of $125,000 or 25% of retirement plan balance, and (3) distributions must begin at a specified date no later than age 85, there are other technical requirements that must be met in order for a DIA to be marketed and sold as a QLAC.

In addition to understanding and complying with the nuances of the IRS regulation, life insurance carriers that want to offer QLAC’s are scrambling to restructure existing DIA products and develop new products that will (a) match consumers’ needs, (b) be competitive, and (c) meet profit objectives. This requires a host of system and other internal changes, state insurance department approvals, and coordination with distribution channels, all of which must occur before life insurance companies will receive their first premiums from sales of this product.

Another important obstacle to the introduction of QLAC’s is the fact that fixed income annuities with deferred income start dates, including DIA’s and fixed index annuities, or “FIA’s,” with income riders, are a relatively new product to which many consumers haven’t been exposed. While both products are designed, and are suitable, for use in retirement income plans, most investment advisors don’t currently have the specialized education, licensing, and experience to understand, let alone offer, these solutions to their clients. See What Tools Does Your Financial Advisor Have in His or Her Toolbox?

So when will you be able to purchase QLAC’s? Although current speculation is that product launch may begin in the fourth quarter of this year, it’s my personal opinion that widespread availability will not occur until well into 2015. This will give investment advisers and consumers, alike, additional time to get more educated about fixed income annuities, including their place in retirement income plans. Once the word spreads, I believe that the demand for fixed income annuities will increase significantly, especially if the timing is preceded by a stock market decline.

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Annuities Deferred Income Annuities

You Don’t Have to Wait Until 85 to Receive Your Annuity Payments

Longevity insurance was recently blessed again by the IRS with its finalization of a regulation allowing the inclusion of an advanced-age lifetime-income option in retirement plans such as 401(k) plans and IRAs.

As discussed in my July 25 MarketWatch article, 6 Ways a New Tax Law Benefits a Sustainable Retirement, “longevity insurance” isn’t an actual product that you can purchase from a life insurance carrier. It’s instead a term that refers to a deferred lifetime fixed income annuity with an advanced age start date, typically 80 to 85.

In a nutshell, IRS’ final regulation allows you to invest up to the lesser of $125,000 or 25% of your retirement plan balance in “qualifying longevity annuity contracts” (QLACs) provided that lifetime distributions begin at a specified date no later than age 85. Although the regulation leaves the door open for other types of fixed-income annuities in the future, QLAC investment vehicles are currently limited to lifetime deferred income annuities, or DIAs.

Suppose you’re concerned about the possibility of outliving your assets and you’re considering investing a portion of your retirement plan in a QLAC. Do you have to wait until age 85 to begin receiving your lifetime annuity payments? Absolutely not. So long as distributions begin no later than the first day of the month following the attainment of age 85, you will be in compliance with the regulation.

Although the regulation doesn’t define the earliest starting date of QLAC payments, based on previous legislation, it would seem to be April 2 of the year following the year that you turn 70-1/2. Why April 2? Per my MarketWatch article, regulations in effect before the new rule allow for inclusion of fixed income annuities without limit provided that the periodic annuity payments (a) begin by April 1 of the year following the year that the owner turns 70-1/2 and (b) are structured so that they will be completely distributed over the life expectancies of the owner and the owner’s beneficiary in compliance with IRS’ required minimum distribution, or RMD, rules.

Let’s suppose that you’re doing retirement income planning when you’re 60 and you’re planning on retiring at 67. In addition to your IRA which has a value of $600,000, you have a sizeable nonretirement portfolio that will not only enable you to defer your Social Security start date to age 70, there’s a high likelihood that you won’t need to withdraw from your IRA until 75.

Despite the fact that you don’t foresee needing income from your IRA until 75, IRS requires you to begin taking minimum annual distributions from your IRA beginning by April 1 of the year following the year that you turn 70-1/2. This is true, however, IRS now also allows you to circumvent the RMD rules by investing a portion of your retirement plan assets in a QLAC. Relying on these rules, you decide to invest $125,000 of your IRA in a QLAC with an income start date of 75. This enables you to longevitize, or extend the financial life of, your retirement using the six ways described in my MarketWatch article.

As you can see, there’s a lot of flexibility when it comes to selecting the start date of your lifetime income distributions from a QLAC. There’s approximately a 13- to 14-year window depending upon your birth date which falls between April 2 of the year following the year that you turn 70-1/2 and age 85. The key is that you must define your income start date at the time of applying for your QLAC. This is a requirement of all deferred income annuities, not just QLAC’s.

Finally, a QLAC may, but is not required to, offer an option to begin payments before the contract’s annuity starting date. While the amount of your periodic distributions will be greater the longer you defer your start date, you don’t have to wait until age 85 to begin receiving lifetime income.

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Annuities Deferred Income Annuities Retirement Income Planning

Consider a Death Benefit When Buying Deferred Income Annuities

If you’re in the market for sustainable lifetime income, you’ve come to the right place if you’re looking at fixed income annuities. A fixed income annuity is a fixed (vs. variable) annuity that provides income payments for your lifetime or for a contractually-defined term.

There are three types of fixed income annuities, each one serving a different purpose in a retirement income plan. The three types are as follows:

The main distinction between the three types of fixed income annuities is the timing of the commencement of income payments. As its name implies, the income from a SPIA begins immediately. The actual start date is one month after the date of purchase assuming a monthly payout.

The income start date of DIA’s and FIA’s with income riders, on the other hand, is deferred. With both DIA’s and FIA’s with income riders, it’s contractually defined and is generally at least one year from the purchase date. Although you choose it when you submit your application, most DIA’s have a defined start date; with some wiggle room available on some products. The income commencement date for FIA’s with income riders is flexible other than a potential one-year waiting period and/or minimum age requirement.

Assuming that a DIA meets your retirement income planning needs, you should always consider including a death benefit feature which is optional with most DIA’s. Keeping in mind that the income start date is deferred, and it’s not unusual for the deferral period to be 10 to 25 years, especially when purchasing a DIA as longevity insurance, you probably don’t want to lose your premium, or investment, if you die prematurely.

If you purchase a DIA without a death benefit or return of premium (“ROP”) feature, and you die during the deferral period, not only will the income never begin, your beneficiaries won’t receive anything either. The death benefit or ROP feature serves the purpose of insuring your investment in the event that you die before your income distributions begin.

So how much does it cost to insure your DIA investment by adding an optional death benefit? To illustrate, I recently evaluated the transfer of $100,000 from one of my client’s IRA brokerage accounts to a DIA. My client is approaching her 65th birthday and, like all individuals with traditional IRA accounts, must begin taking annual required minimum distributions, or “RMD’s,” from her account by April 1st of the year following the year that she turns 70-1/2.

Assuming that $100,000 of my client’s IRA is transferred from her brokerage account to a DIA, and assuming that the income from her DIA begins when she turns 70-1/2, she can expect to receive lifetime monthly income of approximately $600 to $700, depending upon the DIA chosen. In one case, the monthly benefit would be reduced by $2.27, from $691.68 to $689.41 with a death benefit feature. In another case, the monthly benefit would be $1.09 less, at $664.41 without any death benefit vs. $663.32 with a death benefit.

In other words, the cost to insure the return of my client’s investment of $100,000 in the event of her death prior to turning 70-1/2 translates to an annual reduction in lifetime benefits of $13.08 or $27.24, depending on the DIA chosen. Not only is there no question about the value of the death benefit in this situation, it would be negligent in my opinion for any life insurance agent not to illustrate the addition of this feature.

Assuming that a fixed income annuity makes sense for you, and further assuming that a DIA is an appropriate solution as a piece of your retirement income plan, always evaluate your potential lifetime income payout with and without a death benefit.

Categories
Roth IRA

Black Friday – Think Roth IRA Conversion

This Friday is Black Friday. It’s the day after Thanksgiving when major retailers open early promoting significant price reductions on lots of items. It has routinely been the busiest shopping day of the year since 2005.

There’s another major sale taking place as I write this post that’s not being publicized. It’s happening in the investment world. It’s one of those perfect storm moments when a confluence of seemingly unrelated factors occurs that results in a short-lived opportunity for those who act on it.

With the recent 1,000 point, or 8%, drop in the Dow Jones Industrial Average (DJIA), closing at 13,593 on September 14th and finishing at 12,588 on Friday, combined with a distinct possibility of higher income tax rates in 2013, with one notable exception, this is one of those moments for individuals considering a Roth IRA conversion.

Let’s start with the exception which is the result of the last major Roth IRA conversion opportunity. In 2010, individuals who did Roth IRA conversions were given the choice of including income from their conversion on their 2010 income tax returns or deferring it. If they chose the latter, they were required to report 50% of the income on their 2011 income tax returns and 50% on their 2012 returns.

Several of my clients did sizeable conversions in 2010, choosing to defer 50% of their Roth IRA conversion income to 2011 and 50% to 2012. While these individuals have enjoyed 30% increases in the equity portion of their Roth IRA accounts since 2010 as a result of the increase in the DJIA from the 10,000 level that will never be taxed, they will also be including large amounts of income from their 2010 conversions on their 2012 income tax returns. Without offsetting losses or deductions, most of these individuals won’t be good candidates for a 2012 Roth IRA conversion.

If your 2012 taxable income is being inflated by a large amount of deferred income from a 2010 Roth IRA conversion without offsetting losses or deductions, you may not be a good candidate for a 2012 Roth IRA conversion. Assuming that you don’t fall under this exception and you haven’t already done a sizeable Roth IRA conversion in 2012, you should be evaluating this strategy as part of your 2012 year-end income tax planning. Once again, there isn’t one, but two, events that make this a potentially timely transaction depending upon your tax situation, either one of which qualifies as a potential trigger.

While it’s possible that the stock market may decline further and income tax rates may not increase in 2013, the recent significant stock market decline in and of itself presents a Roth IRA conversion opportunity. In addition to avoiding taxation on future appreciation of conversion amounts, Roth IRA conversions result in reduction of taxable IRA accounts which in turn offers two other potential benefits.

Smaller taxable IRA accounts translate to smaller required minimum distributions (“RMD’s”) and reduced taxable income beginning at age 70-1/2. In addition, to the extent that you have less taxable income, you may be able to reduce the amount of your taxable Social Security benefits, providing for a second tax reduction opportunity as well as enhanced retirement income longevity.

While you’re setting your alarm clock to take advantage of all of those Black Friday sales, don’t forget about the Roth IRA conversion sale. It may be one of those short-lived investment opportunities that you won’t see for a long time.

Categories
Annuities Fixed Index Annuities

How Will Withdrawals Affect Your Premium Bonus?

Retirement Income Center

Five weeks ago, ten fixed index annuity (“FIA”) income calculation variables were introduced in the January 23, 2012 post by the same name. The January 30th post delineated the ten variables between contractual vs. situational variables. The first contractual variable, premium bonus availability, prompted the February 6, 2012 post, 8 Questions to Ask Yourself When Analyzing Premium Bonuses which kicked off a series of posts.

The February 6th post answered the first three questions. The February 13, 2012 post, What’s a Reasonable Premium Bonus Percentage?, addressed questions #4 and #5. Question #6 was the subject of last week’s post, How Will a Premium Bonus Affect a Fixed Index Annuity’s Value?

This brings us to question #7: How will withdrawals affect my premium bonus? The answer to this question depends on your contract’s withdrawal charge, free withdrawal, and premium bonus recapture provisions, the latter of which is the sixth contractual variable listed in the January 30, 2012 post.

It’s important to keep in mind that while a premium bonus increases the accumulation value and income withdrawals from a FIA when an income rider has been purchased, there are costs associated with this feature. Two of the costs, potential longer terms and potential lower cap rates, were discussed in last week’s post.

Whenever you take a withdrawal from the accumulation value of a FIA that isn’t a required minimum distribution (“RMD”) assuming your FIA is inside an IRA, it’s subject to a withdrawal charge if (a) your withdrawal is taken during the contract’s specified surrender period and (b) the amount of your withdrawal exceeds the allowable free withdrawal amount, which is generally 10% of the accumulation value after the first contract year.

In addition to the withdrawal charge, your withdrawal may also be subject to a premium bonus recapture charge if you were credited with a premium bonus and your FIA has a premium bonus recapture provision. The recapture charge will be a percentage of your premium bonus for any withdrawals during a specified period, generally the first 10 years of your contract. The percentage may decrease the further into the contract you get.

Let’s look at an example to see the affect of a withdrawal charge and premium bonus recapture provision on a withdrawal from a FIA. Suppose you were credited with a premium bonus of 5% of your initial investment of $100,000, or $5,000, your contract has a free withdrawal provision of 10% of the contract value, and you took a withdrawal of $18,000 in the third contract year when your accumulation value was $120,000, the withdrawal charge was 12%, and the premium bonus recapture charge rate was 6%.

In addition to the withdrawal charge of $720 that would be deducted from your withdrawal, (withdrawal of $18,000 less $12,000 (10% of $120,000), or $6,000, multiplied by 12%), you would also be assessed a recapture charge of 6% of your premium bonus of $5,000, or $300. In this example, a total of $1,020 ($720 + $300), or 5.67% of your withdrawal amount of $18,000 would be deducted, leaving you with a net withdrawal of $16,980 before any further potential reduction for income taxes.

Categories
IRA

To IRA or Not to IRA?

Retirement Income Center

Without going into the details, IRA contributions may be deductible, non-deductible, or partially deductible. Assuming that you’re eligible to make a deductible contribution, should you do it? As with all financial decisions, it depends upon the facts.

Let’s assume that you’re married, you’re both 50 years old, neither one of you is an active participant in an employer-sponsored retirement plan, and your marginal federal income tax rate is 25%. Given this scenario, you would be eligible to make deductible IRA contributions of up to $6,000 each, for a total of $12,000. Forgetting about a potential state income tax deduction, assuming you make maximum contributions, you will reduce your income tax liability by $3,000 ($12,000 x 25%). Looking at it another way, the cost of your IRA contributions is $9,000 ($12,000 less income tax savings of $3,000).

Since your spouse and you are both 50 years old, you’re both eligible to make IRA contributions for another 20 years until age 70-1/2. Assuming that you both continue not to be active participants in an employer-sponsored retirement plan, you will be able to make deductible IRA contributions totaling at least $240,000 ($12,000 x 20), excluding potential additional contributions permitted by legislated contribution limit increases. Per Exhibit 1, after making contributions totaling $240,000, 25%, or $60,000 of which was financed by federal income tax savings, resulting in net out-of-pocket total contributions of $180,000 ($240,000 less income tax savings of $60,000), and assuming earnings of 5%, the total value of both of your IRA’s in 20 years is projected to be approximately $417,000.

That’s pretty awesome. Why wouldn’t you implement this plan? Keeping in mind that a deductible IRA plan is a tax-deferral plan, even though you may receive income tax deductions of $12,000 a year, or a total of $240,000 over 20 years, you, and potentially your heirs, will eventually pay income tax on 100% of your contributions. This must occur beginning at age 70-1/2 when you will be required to take minimum withdrawals from your plan that are calculated each year using the value of your IRA on December 31st of the previous year and your current age. Furthermore, the tax rate on your IRA withdrawals may be greater than the rates at the time when you made your contributions, resulting in greater tax liability than the tax savings you received from your contributions.

As an alternative, especially if you have other qualified retirement plans, you may want to consider taking the same $12,000 and instead make nondeductible contributions to a nonretirement investment account. Administratively, this will be easier since, unlike the IRA situation where you must deposit $6,000 into two separate accounts each year assuming you’re married, you can deposit 100% of your contributions into a single account. Furthermore, unlike an IRA which has an annual contribution limit of $5,000 or $6,000 if you are at least 50 years old, there is no cap on the amount of contributions that may be made to a nonretirement investment account.

To the extent that the investments in your nonretirement account don’t produce current taxable income, they will enjoy tax-deferred growth similar to an IRA. Unlike an IRA where withdrawals are taxable as ordinary income, withdrawals from nonretirement investment accounts are nontaxable. Instead, the sales of securities needed to produce the withdrawals are subject to capital gains. Assuming the securities that are sold have been held for at least a year, under current tax law, any gains, i.e., the excess of sale prices over purchase prices, will be taxed at favorable long-term capital gains rates which in most cases is 15%. To the extent that there is a loss on any sale, it can be offset against capital gains from other sales. Total capital losses in any year are deductible to the extent of capital gains plus an additional $3,000, with any net excess losses carried forward to future years. The availability of existing capital loss carryovers makes this alternative plan even more attractive (See last week’s post, Sizeable Capital Loss Carryover? Rethink Your Retirement Plan Contributions).

Even though a nondeductible nonretirement investment account plan may be preferable to a deductible IRA plan in certain situations, there is greater discipline associated with implementing and maintaining the former plan. Unlike a deductible IRA plan, the absence of the incentive of an annual tax deduction associated with a nonretirement plan generally requires an automatic contribution plan to be in place to ensure that regular contributions are made to the plan each year.

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Retirement Income Planning

Nonretirement Investments – The Key to a Successful Retirement Income Plan

Retirement Income Center

When was the last time someone asked you, “Hey, did you make your nonretirement investment plan contribution this year?” When we think of a retirement income plan, the first thing that typically comes to mind is retirement investments. This includes 401(k), 403(b), SEP-IRA, traditional IRA, Roth IRA, SIMPLE IRA, defined contribution, defined benefit, and other retirement plans. While the maximum allowable contribution varies by plan, the inherent goal of each of them is to provide a source of retirement funds.

With the exception of the Roth and nondeductible traditional IRA’s, both of which receive nondeductible contributions that grow tax-free provided certain rules are followed, all of the other plans enjoy tax-deferred growth. The reason that the growth isn’t nontaxable, and is instead tax-deferred, is because the source of funds for each of these plans is tax-deductible contributions. Whenever this is the case, although plan income, including interest and dividend income and capital gains aren’t taxed, plan distributions are taxable as ordinary income.

While it’s great that Congress has authorized the use of these various types of retirement plans and there are indisputable tax and other advantages associated with each of them, they generally aren’t sufficient for meeting most people’s retirement needs by themselves. Aside from the defined benefit plan, the contribution ceilings, especially those associated with traditional and Roth IRA plans, are inadequate in most cases for building a sizeable nest egg.

Recognizing this fact of life, it’s important to include nonretirement investments in most retirement income plans. What are nonretirement investments? These are simply the same types of investments that you find in retirement plans, i.e., stocks, bonds, mutual funds, exchange traded funds, annuities, CD’s, etc., however, ownership is different. Instead of these assets being owned by a 401(k) , SEP-IRA, Roth IRA, etc., they are owned by you, you and your spouse if married, or perhaps your living trust.

Nonretirement investments enjoy several advantages over retirement investments that make them attractive for funding retirement income plans. For one thing, although contributions to nonretirement investments aren’t tax-deductible, there also aren’t any annual limitations on the amount of contributions that can be made to them. Secondly, investments can be selected that have the potential to match the tax-deferred growth enjoyed by most retirement plans.

Nonretirement investments also offer tax advantages over their retirement plan counterparts when it comes to sales of assets. While gains from sales of assets in retirement plans are nontaxable, they are ultimately taxed as ordinary income at federal tax rates as high as 35% when distributions are taken from a plan. The same gains from sales of nonretirement assets, while they are immediately taxable, have the potential to enjoy favorable long-term capital gains rates of 15% in most cases assuming that the assets that have been sold have been held for more than one year. In addition, unlike losses resulting from sales of investments held within retirement plans that are non-deductible, the same losses in nonretirement plans are considered deductible capital losses.

One of the biggest advantages of nonretirement investments is the ability to control the timing of distributions and the associated exposure to income tax liability. This includes avoidance of required minimum distribution (“RMD”) rules. Beginning at age 70-1/2, with the exception of Roth IRA’s, you’re required to take minimum distributions from your retirement plans each year based on the value of each plan on December 31st of the previous year using an IRS table life expectancy factor, resulting in forced taxation. No such rules exist when it comes to nonretirement investments. In addition, unlike pre-age 59-1/2 distributions from retirement plans that are subject to a federal premature distribution penalty of 10% of the amount of the distribution, there are no such restrictions when it comes to nonretirement investments.

So what is the right mix of retirement vs. nonretirement investments? Read next week’s post to find out.

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Roth IRA

Roth IRA Conversion Insights – Part 1 of 2

Retirement Income Center

Last week’s post completed a six-part series discussing the three primary benefits to be derived from a Roth IRA conversion: (1) elimination of taxation on 100% of the growth of Roth IRA conversion assets, (2) elimination of exposure to required minimum distributions on traditional IRA funds converted to a Roth IRA, and (3) potential reduction in taxation of Social Security benefits.

Part 6, the finale of the series worked through two comprehensive scenarios – one with no Roth IRA conversion and a second with a Roth IRA conversion – to determine which one was projected to result in more total investment assets throughout the life of the scenario. As emphasized in the post, the results of the two scenarios cannot be generalized and used as the basis for determining whether a Roth IRA conversion is appropriate in a particular situation. Furthermore, a detailed analysis needs to be prepared by a retirement income planner for every potential Roth IRA conversion situation.

Having said this, there are several insights to be gained from analyzing the two scenarios that can be applied to any potential Roth IRA conversion analysis. This post will discuss the first three with next week’s post addressing three others.

Actual Results are Likely to be Different Than Projected Results

By far, the most important insight to keep in mind going into any Roth IRA conversion analysis is that actual results are likely to be different than projected results. Without listing them individually, the multitude of assumptions that must be considered and the interaction between them is the reason for this. Contributing to the complexity and uncertainty is the lengthy timeframe that needs to be considered in most situations with the associated potential for multiple changes in the realization of each assumption. In addition, the timeframe needs to include spouses’ and other potential beneficiaries’ lifetimes when applicable.

Multi-Year Income Tax Planning is Critical

When I read, or attend presentations, about Roth IRA conversions, the importance of marginal income tax rates in the year(s) of conversion(s) and the years of distribution from traditional IRA accounts is often emphasized as one of the key factors in a Roth IRA conversion analysis. When I entered the tax profession in 1980 and the top marginal federal income tax rate was 70%, did I know that by 1987, the top rate would be slashed to 38.5% and would stay within three percentage points of this rate for at least the next 25 years with today’s top rate of 35% scheduled to remain in effect through 2012? While a strong argument can be made that a tax increase is inevitable given our huge federal budget deficit, no one knows for certain when this will occur or what future tax rates will be.

It’s not just about tax rates. Comprehensive multi-year income tax planning on both the “front-end” and “back-end” is critical to the success of any Roth IRA conversion analysis. Keeping in mind that a Roth IRA conversion generally shouldn’t be a one-year event, “front-end” planning should include preparation of multi-year income tax projections to determine how much of one’s contributory IRA should be converted and in which years. On the “back-end,” multi-year ongoing projections need to analyze the impact of projected required and discretionary distributions from contributory and Roth IRA accounts as well as nonqualified investment accounts in meeting one’s projected financial needs. Each “back-end” projection should include an analysis of taxable Social Security benefits. Finally, both “front-end” and “back-end” income tax projections need to consider all projected sources of income, losses, and deductions in each year.

Growth of Roth IRA Conversion Assets is Dependent on Roth IRA Conversion Timing

The number one benefit to be derived from a Roth IRA conversion, i.e., elimination of taxation on 100% of the growth of Roth IRA conversion assets, is dependent upon the timing of a Roth IRA conversion relative to stock market valuation assuming that a sizeable portion of one’s Roth IRA conversion portfolio is equity-based. In order to realize this benefit, by definition, there needs to be an increase in the value of one’s Roth IRA from the date(s) of conversion(s) to the future comparison date.

With the Dow Jones Industrial Average increasing by approximately 1,000 points, or 8%, in the past month to finish at 12,811 on Friday combined with a 100% increase, or doubling, from its close of 6,440 on March 9, 1999 a little over two years ago, the determination of the timing of a Roth IRA conversion is more difficult than it was last year at this time. Recharacterization, (see the April 19, 2010 post, Recharacterization – Your Roth IRA Conversion Insurance Policy) is a strategy that’s available for retroactively undoing a Roth IRA conversion that was done prior to a market decline if it’s implemented during a specified limited time period following a conversion.

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Roth IRA Social Security

Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 5 of 6

Retirement Income Center

Parts 3 and 4 of this series addressed the first two of three primary economic benefits associated with a Roth IRA conversion: (1) elimination of taxation on 100% of the growth of Roth IRA conversion assets and (2) elimination of exposure to required minimum distributions, with the first one being the most important and overriding reason in most cases for doing a conversion. This post discusses the third and final benefit – potential reduction in taxation of Social Security benefits.

Economic benefit #3 has intentionally been saved for last. Unlike the first two benefits which will occur provided there is an increase in the value of the Roth IRA after the conversion (benefit #1) and you live until at least age 70-1/2 and you haven’t depleted your traditional IRA (benefit #2), reduction in taxation of Social Security benefits is less certain. This is why this benefit is prefaced by the word, “potential.”

As we know from reading the two-part series, Say Goodbye to Up to 30% of Your Social Security Benefits that was published on January 10, 2011 and January 17, 2011, you can lose up to 30% of your Social Security benefits to federal income tax. Per the series, the amount of benefits subject to tax in a particular year is dependent upon four factors: (1) tax filing status, (2) total amount of Social Security benefits received, (3) adjusted gross income, and (4) tax-exempt income. Generally speaking, factor #3 is the most important one in determining the percentage of benefits that will be lost to federal income tax. The greater your adjusted gross income, or “AGI,” the more likely a larger portion of your Social Security will be eaten up by federal income tax.

Traditional IRA distributions are included in AGI. This includes both voluntary as well as required minimum distributions, or “RMD’s.” Roth IRA distributions, on the other hand, typically aren’t included in AGI since they generally aren’t taxable provided that certain rules are followed regarding the timing of distributions. Assuming that you’ve obeyed the rules, you will reduce your AGI in future years when you would have otherwise taken taxable traditional IRA distributions had you not done your Roth IRA conversion.

While a reduction in AGI doesn’t necessarily translate to a reduction in taxation of Social Security benefits, as illustrated in Exhibit 1 of Part 2 of Say Goodbye to Up to 30% of Your Social Security Benefits, there’s a very good chance that this will happen unless the total of your AGI, tax-exempt income, and 50% of your Social Security benefits exceeds several hundred thousand dollars. Per Part 1 of that series, the loss of 30% of Social Security benefits to taxation won’t occur unless you’re in the top 35% tax bracket. In 2011, the 35% bracket isn’t an issue until taxable income, i.e., AGI less itemized deductions and personal exemptions, exceeds $379,150.

Although reduction in taxation of Social Security benefits won’t occur in every situation, it should nonetheless be included as part of most Roth IRA conversion analyses.

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Roth IRA

Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 4 of 6

Retirement Income Center

Part 3 of this series discussed the first of three primary economic benefits to be derived from a Roth IRA conversion, i.e., elimination of taxation on 100% of the growth of Roth IRA conversion assets. As emphasized in the post, this is the most important and overriding reason in most cases for doing a conversion. The other two benefits are: (1) elimination of exposure to required minimum distributions on traditional IRA funds converted to a Roth IRA and (2) potential reduction in taxation of Social Security benefits. The second benefit is this week’s topic with the third benefit being the subject of Part 5 of this series.

Even though most people generally don’t celebrate half birthdays, Congress, in its infinite wisdom, decided for some reason, that two particular half birthdays are crucial as they pertain to income taxation of distributions from retirement plan assets – age 59-1/2 and age 70-1/2. Congress has determined that if you take distributions from a retirement plan, e.g., 401(k) plan, traditional IRA, etc., before age 59-1/2, this is too soon. If you dare to do this, subject to specified limited exceptions, in addition to paying income tax, you will be assessed a premature distribution penalty of 10% of the amount of your distributions. You may also be subject to a state-imposed penalty which is 2-1/2 percent in California where I live.

At the other extreme, Congress has mandated that 70-1/2 is the drop-dead age by which you must begin taking annual required minimum distributions, or “RMD’s,” from your various retirement plans. Up until this age, your employers and you have benefited by income tax deductions for contributions to your retirement plans and your assets have enjoyed the much-cherished benefit of tax-deferred growth. Beginning at age 70-1/2, it’s time for the government to begin receiving its share of your retirement assets.

If you’re not doing so voluntarily, at age 70-1/2, you must begin taking annual minimum distributions from your various retirement plans based on the value of your retirement assets on December 31st of the previous year and a life expectancy factor as specified in an IRS table. To the extent that either (a) you don’t take your “RMD” in a particular year or (b) the amount of your distribution falls short of your “RMD,” you will pay dearly. IRS’ penalty in this situation is onerous – 50% of the amount that you were suppose to take less the amount that you actually withdrew.

Even though I agree with Congress’ “RMD” justification and believe that the “RMD” tables are fair since they use a life expectancy that extends to 115 years, I personally don’t want to be forced to take X dollars from my IRA account in a particular year if I (a) have other more tax-favored retirement income sources to draw from and/or (b) don’t need the amount specified by IRS to meet my financial needs.

With foresight and proper planning, there is a way to reduce, or potentially eliminate, your exposure to “RMD’s” and associated forced taxation of retirement funds. That way, of course, is to convert a portion, or all, of your traditional IRA’s, including SEP-IRA’s, to Roth IRA’s. Roth IRA accounts are not subject to the “RMD” rules during the owner’s lifetime. While it’s a wonderful goal, reduction or elimination of “RMD’s” shouldn’t be the primary reason in most situations for doing a Roth IRA conversion. Generally speaking, it won’t make sense to pay income taxes today solely for the purpose of avoiding forced taxation of the same assets beginning at age 70-1/2.

As emphasized in Part 3, elimination of taxation on 100% of the growth of Roth IRA conversion assets is the most important and overriding reason in most cases for doing a conversion. To the extent that you’re able to achieve this goal while also minimizing your “RMD” exposure, more power to you!

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Roth IRA

Roth IRA Conversions – Don’t Let the Tax Tail Wag the Dog – Part 3 of 6

Retirement Income Center

As stated last week in Part 2 of this series, there are three primary potential economic benefits to be derived from a Roth IRA conversion, with the first one being the most important and overriding reason in most cases for doing a conversion: (1) elimination of taxation on 100% of the growth of Roth IRA conversion assets, (2) elimination of exposure to required minimum distributions on traditional IRA funds converted to a Roth IRA, and (3) potential reduction in taxation of Social Security benefits. Benefit #1 is the subject of this post with the other two benefits to be discussed in Parts 4 and 5 of this series, respectively.

There are many situations in life that require a leap of faith in order to realize the potential benefits from our decision that result in actually implementing a particular course of action. Like many people, buying my first house comes to mind as one of those such moments. It’s natural for us to simply think of the immediate impact of a particular decision on our daily lives. In the case of my first house purchase, the monthly mortgage payment and all of the other expenses and responsibility associated with home ownership loomed before me as formidable obstacles. It wasn’t until I was able to visualize the long-term potential benefits of my decision that I was able to feel comfortable with signing the dotted line.

Implementing a Roth IRA conversion that requires payment of income taxes today that otherwise wouldn’t be payable for several years in many cases can be a similar experience for many people. Until one visualizes and understands the number one potential benefit and power of a Roth IRA conversion, i.e., elimination of taxation on 100% of the growth of the Roth IRA conversion assets, the traditional IRA that was being considered for conversion will remain untouched.

One of the best examples that I can share with you regarding visualization of potential benefits in connection with a Roth IRA conversion is that of one of my clients, who I will call Mary. Mary had a sizeable IRA account that was formerly her deceased husband’s IRA. She was taking annual required minimum distributions (“RMD’s”) from her IRA, the amount of which was approximately $35,000 in 2008. In 2009, which was the year when RMD’s were waived and Mary wasn’t required to take any distributions from her IRA, Mary, who was 80 years old at the time, did a partial Roth IRA conversion of approximately $100,000, or 20%, of the remaining value of her IRA of approximately $500,000.

Why would an 80-year old who had sufficient nonretirement investments to live on take any distributions from her IRA in a year when she wasn’t required to do so, i.e., 2009, incur income tax liability of approximately $37,000 in connection with her Roth IRA conversion, and, furthermore, not wait until 2010 to do her conversion when she would have the ability to defer 50% of the income from her conversion to 2011 and the other 50% to 2012? Not only didn’t she “let the tax tail wag the dog,” Mary, at her advanced age, was able to visualize the elimination of taxation on growth of her Roth IRA account during not only her remaining lifetime, but also that of her daughter as well.

To put things in historical perspective, the stock market had been spiraling downward, with the Dow Jones Industrial Average decreasing from a high of about 14,000 in October, 2007 to a low of around 6,500 in the beginning of March, 2009. At the time when Mary did her Roth IRA conversion in March, 2009, a sizeable portion of which was invested in equities, the Dow was right at about 7,000. With the Dow closing at 12,321 on Friday, subject to a potential future decline in value, Mary has experienced a 75% increase in just two years in the value of the equity portion of her Roth IRA that will never be taxed. With approximately half of her Roth IRA invested in equities, the appreciation of Mary’s Roth IRA account since she did her conversion in March, 2009 has already exceeded the income tax that she paid in connection with her conversion. The growth in Mary’s Roth IRA will never be taxed during Mary’s lifetime nor that of her daughter.

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Income Tax Planning Social Security

Increase Your After-Tax Social Security Benefits – Part 3 of 4

Retirement Income Center

Since it’s Super Bowl Sunday as I write this post, let’s discuss strategy as it pertains to winning the Social Security benefit game. If you want to be successful at increasing your after-tax Social Security benefits, you need to have a winning strategy. Hopefully you read Part 1 of this post and if you’re not yet receiving benefits, you’ve begun to implement your pre-benefit receipt game plan.

Once you’ve begun receiving your retirement benefits, there are two halves to winning the game when it comes to increasing after-tax benefits: (1) reduce taxable benefits, and (2) reduce the tax attributable to your benefits. If you’ve read Parts 1 and 2 and/or the previous two-part Say Goodbye to Up to 30% of Your Social Security Benefits series, you know that reduction of taxable benefits is all about minimizing the three components of “combined income,” i.e., (1) 50% of Social Security benefits, (2) adjusted gross income, and (3) tax-exempt income. Components #1 and #3 were addressed in Part 2.

Let’s turn our attention to component #2 – adjusted gross income, or “AGI.” As defined in Retirement Income Visions‘ Glossary, “adjusted gross income” is equal to gross income from taxable sources less deductions from gross income that are allowable even if you don’t itemize deductions. To the extent that you’re able to (a) reduce your gross income from taxable sources and/or (b) increase your deductions from gross income, you will reduce the amount of your adjusted gross income and, in turn, reduce your “combined income.”

Reduce Gross Income From Taxable Sources

Even though you can reduce your taxable Social Security benefits by reducing your gross income, why would you want to do this? After all, don’t you want to maximize your salary, self-employment income, pension income, rental income, partnership income, interest and dividend income, capital gains, etc.? Absolutely — with a caveat. Your goal should always be to maximize cash flow while minimizing taxable income. For those of you who receive annual Schedule K-1’s from entities in which you are a partner, shareholder, or limited liability company member, you know that quite often there’s a difference between what shows up on your K-1 as taxable income vs. the cash distributions you receive.

How do you reduce your gross income when you’re receiving Social Security benefits without negatively impacting your cash flow? Here are six ways to do this:

  • For taxable investments, i.e., nonretirement accounts, invest in immediate and/or deferred income annuities since a portion (sometimes substantial) of the distributions will be nontaxable.
  • Sell assets with unrealized losses to offset capital gains recognized earlier in the year.
  • Minimize distributions in excess of required minimum distributions (“RMD’s”) from self-managed non-Roth IRA retirement plans.
  • Minimize taxable Roth IRA conversions.
  • If you have net rental income from your rental property(ies), transfer mortgage balances from your home to one or more of your rental properties to increase your rental property interest deduction up to the amount of your net rental income. Even though your overall mortgage interest deduction may be unchanged, you may be able to reduce your taxable Social Security benefits.
  • Look for opportunities to sell properties that have passive activity loss carry forwards in order to recognize the losses.

Increase Deductions From Gross Income

When we think of tax deductions, what comes to mind most often are “itemized deductions,” including mortgage interest, real estate taxes, charitable contributions, etc. While these types of deductions reduce taxable income, they don’t reduce adjusted gross income. Although the opportunities in this area are limited, and assuming you’re not paying alimony, here’s three possibilities:

  • If you’re less than 70-1/2, maximize your IRA deduction.
  • If you’re self-employed, maximize your self-employed pension plan, i.e., SEP-IRA deduction.
  • If you’re not eligible for Medicare, establish and maximize contributions to a health savings account (“HSA”).

By the time you read this post, Super Bowl Sunday will be a memory. If you’re receiving Social Security benefits, your game and associated battle to reduce the taxation of your benefits is ongoing. Do you have a winning strategy in place to maximize your after-tax Social Security benefits?