Our Social Security system began back in 1935, with a promise from the federal government that almost all retirees would receive a lifetime retirement income. For almost 50 years, this retirement income was free from taxation. In the last 20 years, demands brought on by the federal deficit have changed the tax-free status of these benefits.

In 1984, Congress decided to make the first change. It began taxing these benefits for seniors who have income exceeding certain levels. This tax change only lasted about 10 years, until 1994, when Congress increased the tax again by adding another income level and increasing the potential taxable percentage of the retirees benefit.

Fortunately, there are some strategies using deferred annuities that can help to reduce this tax and possibly return the Social Security benefit back to its original status.

A couple of steps are needed to develop a good strategy for your client. We must see if the client will be taxed on his or her Social Security benefit. Then, we can calculate the tax savings that can be realized by using deferred annuities.

The first step in determining if the Social Security income will be taxable is to calculate the “provisional income.” The provisional income is equal to the adjusted gross income, modified to include tax exempt interest, reverse some other deductions and finally, 50% of the Social Security benefit. (See Table 1.)

This provisional income is then measured against two income tiers. If the provisional income is less than the first tier amount, no tax is due on the Social Security benefit. If the provisional income is greater than the first tier amount, then tax is due on 50% of the lesser of the excess over the first tier amount or the Social Security benefits received.

If the provisional income exceeds the second tier amount, then 50% of the amount between the two tiers is taxed and 85% of the amount in excess of the second tier, or the Social Security benefit, if less.

What are the first and second tier amounts? They vary by filing status. (See Table 2.)

So how can annuities help in this situation? Most retirees have many sources of income, such as pensions, Social Security, IRAs and investment interest/gains. Of these major categories, investment interest is the only category that the client has the discretion to reduce. Pensions and Social Security have fixed benefits. IRAs require minimum distributions. Only the interest income can be sheltered from taxation by using an ordinary tax-deferred annuity.

The tax-deferred annuity is used to reduce the provisional income by transferring the income producing investments into the annuity. The income building up in the annuity is not subject to current taxation nor is it included in the provisional income calculation. If the provisional income can be reduced below the second tier, then taxes on the Social Security income can be reduced. And, if the provisional income can be reduced below the first tier, then the Social Security benefit will not be taxed at all.

Lets run through a simple example to illustrate this concept. Suppose two married retirees have Social Security benefits of $20,000 per year, pension benefits of $25,000, and an IRA where the required minimum distribution is $6,000 in 2003. Assume they also have $10,000 of income from approximately $200,000 of savings invested in CDs, tax-exempt bonds, or income generating stocks, and this interest income is not needed to maintain their current standard of living.

The provisional income = (50% of the $20,000) + $25,000 + $6,000 + $10,000 = $51,000.

This $51,000 of provisional income, applied to the appropriate tiers shown above, means that 85% of the excess over $44,000 will be taxed, and 50% of the difference between $32,000 and $44,000. Thats 85% of $7,000 plus 50% of $12,000 or $11,950 of Social Security income being taxed.

Tax on some of this income can be avoided if the $200,000 of investments are placed in a tax-deferred annuity. The interest building up in the annuity is not included in the provisional income calculation. So the new calculation is:

The provisional income = (50% of the $20,000) + $25,000 + $6,000 = $41,000. This $41,000 of provisional income is between the two tiers, so only 50% of the excess over the lower tier of $32,000, or $4,500 is taxable. So with the annuity, $7,450 ($11,950 minus $4,500) of the Social Security benefit can be removed from taxation.

In this example, purchasing the annuity not only saves taxes in the current year on the $10,000 of interest income, but it also eliminates $7,450 of the Social Security income from taxation. At a 15% tax rate that is a savings of $1,500 on the $10,000 and an additional $1,118 on the Social Security benefit, for a total tax savings of $2,618. It is possible that the client could fall in the 27% tax bracket and the savings would be greater. Additional help with the tax calculations can be found in IRS Publication 915.

One additional point should be made when using this strategy. Taxes eventually will have to be paid on the interest credited to the annuity when funds are withdrawn. Or, if the funds are never withdrawn, taxes will be due at death. However, the annuity does provide significant leverage. In the above example, the $10,000 of interest credited to the annuity eventually will be taxable. However, $17,450 was removed from current year taxation. I would trade eliminating current taxes on $17,450, for future taxes on $10,000 any day of the week.

The use of a tax-deferred annuity can save significant tax dollars for those taxpayers receiving Social Security with total income levels in excess of $25,000 ($32,000 if married).

Stephen C. Wilson, ASA, MAAA, FLMI, CLU, CHFC, is

assistant vice president and product actuary for

Standard Life Insurance Company of Indiana.

He can be reached at stevewilson@smancorp.com.


Reproduced from National Underwriter Life & Health/Financial Services Edition, November 14, 2003. Copyright 2003 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.