Your Immediate Annuity May Give You a Double Tax Break
If you're concerned about having enough income to last and you want to maximize it while reducing taxes – perhaps an immediate annuity is for you. You'd ensure an income for life but it'd depend on your age and sex. When you die, that's it – your investment is gone. But this may be fine in your case if you desire to maximize your cash flow.
How does the immediate annuity help reduce tax?
Each payment from an immediate has both a taxed and untaxed portion. This is due to an IRS rule that may make no logical sense but it helps seniors interested in reducing taxes. The untaxed part is your basis –i.e. your purchase price. Its fraction of each payout - called the exclusion ratio - remains fixed at the ratio of your purchase price to the expected total payout based on your remaining life expectancy. This part of the annuity payment is not taxed over term of the annuity.
To illustrate the power of reducing taxes, we'll estimate the total payout for 15 years for a 65 year old male living in California who invests $100,000 - based on a leading supplier of immediate annuity quotations. Fifteen years is the IRS's expected life at of a 65 year old man. Their estimate gives $675/month – with no beneficiary (lower payouts would include guaranteed term payouts to beneficiaries). The total payout over 15 years at $675/month is $121,500. So the exclusion ratio is 82.3% (= $100,000/$121,500)! Therefore, of each payment received 82% is not subject to tax for the next 15 years and this makes immediate annuities a powerful choice for reducing taxes.
So, your annual income from your $100,000 immediate annuity investment is $8,100 of which only $1,434 is taxable. At a 25% marginal tax rate , you net about $7,700 per year.
If you had invested your $100,000 in 10 to 30 year corporate bonds at the prevailing 5% rate , you'd generate a $5,000 yearly income but all of it taxable. Again at a 25% marginal tax rate, your net income is $3,750 – about half as much as you net from your annuity. So a large part of your increased cash flow comes from reducing taxes using the exclusion ratio that IRS provides for an immediate annuity.
Purchasing tax free bonds – at a lower prevailing interest rate- may give you more net income, but still significantly less than from an immediate annuity. Additionally, taxfree bonds will not provide the tax reducton feature described below.
Further possible tax reductions on taxable social security
Social security becomes subject to tax for provisional incomes beyond $25,000 for single individuals, and $32,000 for married filing jointly. It can be taxed up to 85% beyond the $34,000 and $44,000 thresholds respectively. This provisional income includes all taxable income, 50% of your social security income, and tax free bond income. Reducing taxes on social secuity income is an obvious desire of most seniors.
Your immediate annuity income adds only $1,434 to your provisional income compared to $5,000 from 5% tax free bonds or corporate bonds. If you're near or within the above threshold levels, you'll reap additional tax savings from social security income that remains untaxed due to your annuity's lower contribution to provisional income. Reducing taxes in this manner could be an additional $1,000 annually to spend.
Note that if select lifetime payments for your immediate annuity and live beyond your life expectancy, reducing taxes with your immediate annuity no longer works as all payments become taxable. However, most immediate annuity owners are happy to live beyond their life expectancy to give up tax reduction.
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A strategy to ensure retirement income that will keep pace with inflation and will provide income in the future is to use longevity annuities. These annuities can be funded with a small portion of your savings and begin to provide income at a future date. A good overview and the strategy is at http://www.longevityannuities.com
Good point about making sure to try to minimize taxes. If you can control what you will be taxed on and stay under the brakets it makes alot of sense to use the annuity like you said.
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A more effective comparison for investors would be comparing an immediate annuity to a stock or bond index mutual fund that is outside an annuity account, rather than comparing the annuity to a non-index fund or fixed rate type of investment.
An immediate annuity that pays you a stream of periodic payments has no tax-deferral advantage over a stock or bond index mutual fund that is outside an annuity account (see the cash flow analysis on the annuityevaluator.com website).
An index mutual fund that is outside an annuity account is passively managed due to its low turnover of stocks or bonds, and consequently generates few short-term capital gains and, therefore, is mostly taxed at a low long-term capital gains tax rate, compared to annuity income which is taxed at the higher ordinary tax rate. Some of the income from an annuity is excluded from taxes, but the higher tax rate offsets the benefit of the exclusion.