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.
