Annuities Fixed Index Annuities

Fixed Index Annuity Income Rider Similarities to Social Security – Part 4 of 4

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:

  1. Limited income tax deduction for investment funding
  2. Tax-deferred growth
  3. 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.

Tax-Deferred Growth

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.

Retirement Income Planning

Nonretirement Investments – The Key to a Successful Retirement Income Plan

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.

Roth IRA

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

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!