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Retirement Planning > Retirement Investing

Post-Retirement Planning

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After a long, hard struggle, millions of Americans are just about to reach the promised land of retirement–a time when they can sit back, relax, and let their accumulated investments and Social Security benefits support them for the balance of their lives. Or so they thought. Forget about the horror stories of Social Security being significantly diminished or disappearing altogether. Let’s assume, for the moment, that Social Security continues on its merry way for the next few decades. How many Americans do you think are aware that as much as 85% of their Social Security benefit is subject to income tax, and that part of their potential future tax problem will be caused by the earnings on their investments? The answer is short and sobering: Very few.

To prove the veracity of this lack of awareness, try asking your clients the following questions:

1. How much are you presently receiving in Social Security?

2. Do you know how much you are actually paying in income tax on that benefit?

3. Are you earning any income from your investments?

4. Are you investing in tax-exempt municipal bonds? If are investing in tax-exempt munis, have you received any income from them?

5. Has your advisor ever done a tax liability calculation for you?

John D. Rockefeller had a saying, “Why pay taxes on money that you don’t need?” Granted, sheltering Rockefeller’s surplus could generate full-time work for any multinational accounting firm, but even senior citizens with a fraction of the legendary oilman’s financial empire still can afford the same tax-deferred treatment for their money. In fact, the threefold manner in which a fixed annuity can defer taxes is matched only by its ability to triple compound the interest.

There are at least three legal ways to accumulate money in this world: Win it, make it, and earn interest. Inheriting money could be a fourth, but this article isn’t going to get morbid. Once your clients have accumulated wealth, their next logical course of action is to attempt to protect it and, we hope, earn some interest in the process. Fixed annuities have been an excellent vehicle for protecting investors not only from stock market dips, but also from the Internal Revenue Service. While a senior client’s money is safely out of the government’s reach, via the 1099 form, it’s also earning interest upon interest upon interest.

The compounding advantages that tax-deferred annuities give to their policyholders include interest on principal, interest on interest they have received in previous years, and interest on the money that is not being paid out in state and federal income taxes each year. While your clients’ money is earning “triple-time,” it’s also being deferred because fixed annuities can defer state and federal taxes while possibly eliminating taxation on their Social Security benefits altogether.

Never Stop Planning

Most people spend a lifetime saving and investing for their retirement and never spend any time planning during their retirement. The consequence of not planning during retirement is most commonly the payment of unnecessary income taxes, resulting in the loss of what could be a full retirement income check or two over the course of the year.

Many people are not even aware of the income taxation on their Social Security benefits, yet according to the U.S. House Ways and Means Committee 2003 Green Book, approximately 15.5 million Social Security recipients paid $19 billion in taxes on their Social Security benefits. That is not to say that all people fall into this income tax situation, since many don’t, but the only important question is whether your clients are in that situation.

Depending on your client’s specific retirement income sources and his particular circumstances, his or her retirement income may be causing unnecessary taxation on some portion of his Social Security benefits. With proper planning, his retirement income, together with his Social Security income, may be structured so that he reduces his overall income taxes, increases his retirement income, increases the monies that he saves for emergencies, and provides a hedge for future income needs, helping to minimize the effects of inflation over time. By doing so, he gets more and Uncle Sam gets less.

Interest income earned and credited on annuities is not included in the calculation of threshold income until that income is withdrawn. Income received from an annuity can be structured so a significant portion is not includable as income but rather is treated as a return of principal, thus not subjecting the recipient to income taxation.

While the actual calculation for determining the Social Security benefit tax is quite complicated, a simplified version is illustrated below to give you an idea of what’s involved.

The formula is divided into three tiers, where the second tier is the basic benefit tax on 50% of your Social Security benefits. If your income exceeds the limits of the second tier, then the third tier determines the Social Security benefit tax, based on 85% of the benefits.

To illustrate the principle, let’s use an example of a married couple, where one spouse is retired and collects Social Security benefits (SSB) of $14,000, while the other, younger spouse still works part time, earning annual wages of $20,000. The couple’s current base amount of $56,000 in income–which includes $10,000 in required minimum distribution from an IRA and annual dividends of $15,000–subjects their SSB to 85% taxation, as shown below:

While there are several solutions to reducing this hypothetical couple’s income, such as asking the one spouse to quit her part-time job, our aim is to reduce taxable investment income, not overall income. By repositioning the hypothetical investment equivalent of $240,000, which generates the excess income of $12,000, based on a 5% interest rate, we can reduce their SSB taxation bracket from 85% to 50%:

What are eligible investments that we can reposition in order to reduce current taxable income? Certainly any investment that triggers countable income will not work. One exception may be government-issued Series E bonds, since the interest income from those bonds is deferred until cashed. Other exceptions may include non-dividend-paying stocks, non-rental real estate held for investment purposes, and deferred annuities.

Provided the client does not need the current income, a deferred annuity, as long as the income or earnings remain deferred, is not counted in the formula. Conversely, any distributions from the annuity would be counted. A deferred annuity–unlike other investment choices–also offers a death benefit, nursing home waiver, and income guarantees should any of these features be needed in the future.

By moving $240,000 from their investment portfolio to a deferred annuity, we can defer the recognition of the excess interest income and reduce the amount of our couple’s Social Security benefit subject to taxation.

The strategy of repositioning assets into annuities may not be for everyone. In fact, many Social Security recipients may not be able to afford a reduction in their current income in order to reduce the taxation of their Social Security benefits. The ideal candidate for this strategy is a person who is between the ages of 65 and 75, is in good health, and is receiving retirement income of $50,000 or more, in addition to her Social Security benefits.

The benefits of a Social Security checkup for your clients are multifaceted, helping both the client and you as the advisor.

One objective is to determine whether any of your client’s assets can be repositioned to reduce the tax on Social Security benefits. Another objective is to determine if any assets can be better allocated to meet the client’s overall objectives, which might include higher income and lower income taxes, for instance. A third objective is the potential for referrals, since all clients have friends and family within their own economic circles. After all, they, too, might benefit from a Social Security benefit checkup.

Peter Radloff is vice president of advanced markets at Jackson National Life Distributors, Inc. in Denver. He can be reached at [email protected]


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