Here’s an example I use often for a single retired taxpayer. Say you get $24,000 per year from Social Security and have $16,000 of other income including $3,000 of interest on your savings. Your combined income is $28,000 (the sum of 1/2 the $24,000 of Social Security and $16,000), making $1,500 of your Social Security taxable. With a standard deduction of $13,850, your tax bill is $368. (I will use the 2019 tax schedules throughout the examples.)
The pitch is to move the savings to an annuity so your AGI drops by $3,000. Now, your combined income is $25,000 so none of your Social Security is taxable. Your bill drops to $0 because the standard deduction exceeds the $13,000 of taxable income remaining.
The potential strategic flaw is that even with some Social Security taxable, the effective tax rate applicable to you now is likely to be less than the rates that will apply later.
Earnings are only deferred not avoided. By law, the earnings come out first. When a withdrawal occurs, those earnings are taxed as part of your AGI. Back to our example, a few years after buying the annuity you need $6,000. That $6,000 is all earnings, the combined income increases to $31,000 and the tax bill would be $818.
Note that while $6,000 is twice $3,000, the tax bill more than doubles the $368 bill that you were trying to avoid when the $3,000 in interest was part of AGI. This happens because more Social Security becomes taxable with the additional income. The larger the earnings deferral, the bigger the potential tax bill especially if the added income pushes the taxpayer into a higher bracket.
The counterpoint from the salespeople is if you never remove money from the annuity, you don’t get taxed on the earnings. True but the beneficiaries will be taxed and at their rates. If you leave these funds to gainfully employed people or ones who otherwise have means, it is easy for the taxes due owed by the beneficiaries to exceed the taxes you saved during your lifetime.
Again, the issue here isn’t that these strategies never work out, necessarily. It’s just that they aren’t applicable to a lot of clients, don’t have the payoff touted, or often backfire. I’ll share some more at another time.
Dan Moisand, CFP, has been featured as one of America’s top independent financial advisors by Financial Planning, Financial Advisor, Investment Advisor, Investment News, Journal of Financial Planning, Accounting Today, Research, Wealth Manager, and Worth magazines. He practices in Melbourne, Fla. You can reach him at [email protected].