Tax-Deferred Annuities: Are They Right for You?
Tax-deferred annuities can be a valuable tool, particularly for retirement savings. However, they are not appropriate for everyone.
Five questions to consider
Think about each of the following questions. If you can answer yes to all of them, an annuity may be a good choice for you.
1. Are you making the maximum allowable pretax contribution to employer-sponsored retirement plans (a 401(k) or 403(b) plan through your employer, or a Keogh plan or SEP-IRA if you are self-employed), or to a deductible traditional IRA? These are tax-advantaged vehicles that should be fully utilized before you contribute to an annuity.
2. Are you making the maximum allowable contribution to a Roth IRA, Roth 401(k), or Roth 403(b), which provide additional tax benefits not available in a nonqualified annuity?
3. Will you need more retirement income than your current retirement plan(s) will provide? If you begin making the maximum allowable contributions to both a qualified plan and an IRA in your 30s or early 40s, you may have enough retirement income without an annuity.
4. Are you sure you won't need the money until at least age 59½? Withdrawals from an annuity made before this age are usually subject to a 10 percent early withdrawal penalty tax on earnings levied by the IRS.
5. Will you take distributions from your annuity on an ongoing basis throughout your retirement? You typically have the option of making a lump-sum withdrawal from an annuity, but this is almost always a bad idea. If you do, you'll have to pay taxes on all of the earnings that have built up over the years. If you take gradual distributions, you pay taxes a little at a time, allowing the rest of the money to continue growing tax deferred. In addition, if the annuity is nonqualified and you elect to receive an annuity payout, you will enjoy an exclusion allowance on each payment, in which a portion of each payment is considered a return of principal and is not taxable.
Note: Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk including the possibility of loss of principal. Variable annuities contain fees and charges including, but not limited to mortality and expense risk charges, sales and surrender (early withdrawal) charges, administrative fees and charges for optional benefits and riders. Variable annuities are sold by prospectus. You should consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from the insurance company issuing the variable annuity, or from your financial professional. You should read the prospectus carefully before you invest.
Updated 12/7/2011
Tax Planning for Annuities
Favorable tax treatment is one of the main reasons for buying an annuity. But what exactly are the tax benefits? And are there any drawbacks? It's important to know the answers to these questions before deciding whether to purchase an annuity.
Of course, any information pertaining to taxes is complex, full of exceptions, and subject to change. This discussion deals with the general rules for taxation of annuities--you should consult a tax advisor for more specific information before you take any action.
Taxation of premiums
Annuities are typically funded with after-tax dollars. So, the money you pay into an annuity (in the form of premiums) is nondeductible. By placing funds in an annuity, you will not realize any current income tax savings, unlike putting money into a traditional IRA, 401(k) plan, or other employer-sponsored retirement plan.
Tax-deferred growth
Unlike most investments, an increase in the value of an annuity from interest is not currently taxable. Generally, annuity funds are allowed to grow tax deferred until they're distributed, at which time the owner will pay ordinary income tax on all gains.
Taxation of premature withdrawals
Withdrawals taken before age 59½ may be subject to a 10 percent IRS penalty tax unless an exception applies. When you make a withdrawal from an annuity, the IRS assumes that earnings are withdrawn first. The 10 percent penalty applies to the earnings portion of a withdrawal. So, early withdrawals are costly from a tax standpoint.
For example, if your annuity has grown by $1,000 since you purchased it, a $500 withdrawal would be considered 100 percent interest and would be subject to the 10 percent penalty--in this case, $50. In addition, because the entire withdrawal represents earnings, it would be subject to ordinary income tax. If you are in the 25 percent tax bracket, your income tax liability on the withdrawal would be $125. Adding this to the early withdrawal penalty, $175 of your $500 withdrawal would end up in the IRS's pocket.
Taxation of scheduled distributions
If you choose an annuitization option, you will begin receiving regular distributions from your annuity over a predetermined period of time. Each distribution consists of two components: principal (a return of the money you paid into the annuity) and earnings. The percentages of principal and earnings of each distribution will depend on the annuitization option chosen. Again, the earnings portion of each distribution will be treated as ordinary income. Also, depending on the annuitization option chosen, the 10 percent penalty rule may not apply.
Note: Annuity guarantees are subject to the claims-paying ability of the annuity issuer.
Note: Variable annuities are long-term investments suitable for retirement funding and are subject to market fluctuations and investment risk including the possibility of loss of principal. Variable annuities contain fees and charges including, but not limited to mortality and expense risk charges, sales and surrender (early withdrawal) charges, administrative fees and charges for optional benefits and riders. Variable annuities are sold by prospectus. You should consider the investment objectives, risk, charges and expenses carefully before investing. The prospectus, which contains this and other information about the variable annuity, can be obtained from the insurance company issuing the variable annuity, or from your financial professional. You should read the prospectus carefully before you invest.
Taxation of lump-sum distributions
Taking a lump-sum distribution of your annuity funds can have many consequences. If you make this election within the first few years after purchasing your annuity, you may be subject to surrender charges imposed by the issuer. In any case, the earnings portion of the distribution will be treated as ordinary income in the year you take the distribution. Also, keep in mind that a large lump-sum distribution could actually push you into a higher tax bracket, dramatically increasing your tax liability.
Updated 12/7/2011
Tax Planning for Income
The goal of income tax planning is to minimize your federal income tax liability. You can achieve this in different ways. Typically, though, you'd look at ways to reduce your taxable income, perhaps by deferring your income or shifting income to family members. You should also consider deduction planning, investment tax planning, and year-end planning strategies to lower your overall income tax burden.
Postpone your income to minimize your current income tax liability
By deferring (postponing) income to a later year, you may be able to minimize your current income tax liability and invest the money that you'd otherwise use to pay income taxes. And when you eventually report the income, you may be in a lower income tax bracket.
Certain retirement plans can help you to postpone the payment of taxes on your earned income. With a 401(k) plan, for example, you contribute part of your salary into the plan, paying income tax only when you withdraw money from the plan (withdrawals before age 59½ may be subject to a 10 percent penalty). This allows you to postpone the taxation of part of your salary and take advantage of the tax-deferred growth in your investment earnings.
There are many other ways to postpone your taxable income. For instance, you can contribute to a traditional IRA, buy permanent life insurance (the cash value part grows tax deferred), or invest in certain savings bonds. You may want to speak with a tax professional about your tax planning options.
Shift income to your family members to lower the overall family tax burden
You can also minimize your federal income taxes by shifting income to family members who are in a lower tax bracket. For example, if you own stock that produces a great deal of dividend income, consider gifting the stock to your children. After you've made the gift, the dividends will represent income to them rather than to you. This may lower your tax burden. Keep in mind that you can make a tax-free gift of up to $13,000 per year per recipient without incurring federal gift tax.
However, look out for the kiddie tax rules. Under these rules, for children (1) under age 18, or (2) under age 19 or full-time students under age 24 who don't earn more than one-half of their financial support, any unearned income over $1,900 is taxed at the parent's marginal tax rate. Also, be sure to check the laws of your state before giving securities to minors.
Other ways of shifting income include hiring a family member for the family business and creating a family limited partnership. Investigate all of your options before making a decision.
Deduction planning involves proper timing and control over your income
Lowering your federal income tax liability through deductions is the goal of deduction planning. You should take all deductions to which you are entitled, and time them in the most efficient manner.
As a starting point, you'll have to decide whether to itemize your deductions or take the standard deduction. Generally, you'll choose whichever method lowers your taxes the most. If you itemize, be aware that some of your deductions may be disallowed if your adjusted gross income (AGI) reaches a certain threshold figure. If you expect that your AGI might limit your itemized deductions, try to lower your AGI. To lower your AGI for the year, you can defer part of your income to next year, buy investments that generate tax-exempt income, and contribute as much as you can to qualified retirement plans.
Because you can sometimes control whether a deductible expense falls into the current tax year or the next, you may have some control over the timing of your deduction. If you're in a higher federal income tax bracket this year than you expect to be in next year, you'll want to accelerate your deductions into the current year. You can accelerate deductions by paying deductible expenses and making charitable contributions this year instead of waiting until next.
Investment tax planning uses timing strategies and focuses on your after-tax return
Investment tax planning seeks to minimize your overall income tax burden through tax-conscious investment choices. Several potential strategies may be considered. These include the possible use of tax-exempt securities and intentionally timing the sale of capital assets for maximum tax benefit.
Although income is generally taxable, certain investments generate income that's exempt from tax at the federal or state level. For example, if you meet specific requirements and income limits, the interest on certain Series EE bonds (these may also be called Patriot bonds) used for education may be exempt from federal, state, and local income taxes. Also, you can exclude the interest on certain municipal bonds from your federal income (tax-exempt status applies to income generated from the bond; a capital gain or loss realized on the sale of a municipal bond is treated like gain or loss from any other bond for federal tax purposes). And if you earn interest on tax-exempt bonds issued in your home state, the interest will generally be exempt from state and local tax as well. Keep in mind that although the interest on municipal bonds is generally tax exempt, certain municipal bond income may be subject to the federal alternative minimum tax. When comparing taxable and tax-exempt investment options, you'll want to focus on those choices that maximize your after-tax return.
In most cases, long-term capital gain tax rates are lower than ordinary income tax rates. That means that the amount of time you hold an asset before selling it can make a big tax difference. Since long-term capital gain rates generally apply when an asset has been held for more than a year, you may find it makes good tax-sense to hold off a little longer on selling an asset that you've held for only 11 months. Timing the sale of a capital asset (such as stock) can help in other ways as well. For example, if you expect to be in a lower income tax bracket next year, you might consider waiting until then to sell your stock. You might want to accelerate income into this year by selling assets, though, if you have capital losses this year that you can use to offset the resulting gain.
Note:You should not decide which investment options are appropriate for you based on tax considerations alone. Nor should you decide when (or if) to sell an asset solely based on the tax consequence. A financial or tax professional can help you decide what choices are right for your specific situation.
Year-end planning focuses on your marginal income tax bracket
Year-end tax planning, as you might expect, typically takes place in October, November, and December. At its most basic level, year-end tax planning generally looks at ways to time income and deductions to give you the best possible tax result. This may mean trying to postpone income to the following year (thus postponing the payment of tax on that income) and accelerate deductions into the current year. For example, assume it's December and you know that you're in a higher tax bracket this year than you will be in next year. If you're able to postpone the receipt of income until the following year, you may be able to pay less overall tax on that income. Similarly, if you have major dental work scheduled for the beginning of next year, you might consider trying to reschedule for December to take advantage of the deduction this year. The right year-end tax planning moves for you will depend on your individual circumstances.
Updated 12/7/2011
Taxation of Investments
It's nice to own stocks, bonds, and other investments. Nice, that is, until it's time to fill out your federal income tax return. At that point, you may be left scratching your head. Just how do you report your investments and how are they taxed?
Is it ordinary income or a capital gain?
To determine how an investment vehicle is taxed in a given year, first ask yourself what went on with the investment that year. Did it generate income, such as interest? If so, the income is probably considered ordinary. Did you sell the investment? If so, a capital gain or loss is probably involved. (Certain investments can generate both ordinary income and capital gain income, but we won't get into that here.)
If you receive dividend income, it may be taxed either at ordinary income tax rates or at the rates that apply to long-term capital gain income. Currently, dividends paid to an individual shareholder from a domestic corporation or qualified foreign corporation are generally taxed at the same rates that apply to long-term capital gains. These rates are 15 percent for an individual in a marginal tax rate bracket that is greater than 15 percent, or 0 percent for an individual in the 10 or 15 percent marginal tax rate bracket. But special rules and exclusions apply, and some dividends (such as those from money market mutual funds) continue to be treated as ordinary income.
The distinction between ordinary income and capital gain income is important because different tax rates may apply and different reporting procedures may be involved. Here are some of the things you need to know.
Categorizing your ordinary income
Investments often produce ordinary income. Examples of ordinary income include interest and rent. Many investments--including savings accounts, certificates of deposit, money market accounts, annuities, bonds, and some preferred stock--can generate ordinary income. Ordinary income is taxed at ordinary (as opposed to capital gains) tax rates.
But not all ordinary income is taxable--and even if it is taxable, it may not be taxed immediately. If you receive ordinary income, the income can be categorized as taxable, tax exempt, or tax deferred.
· Taxable income: This is income that's not tax exempt or tax deferred. If you receive ordinary taxable income from your investments, you'll report it on your federal income tax return. In some cases, you may have to detail your investments and income on Schedule B.
· Tax-exempt income: This is income that's free from federal and/or state income tax, depending on the type of investment vehicle and the state of issue. Municipal bonds and U.S. securities are typical examples of investments that can generate tax-exempt income.
· Tax-deferred income: This is income whose taxation is postponed until some point in the future. For example, with a 401(k) retirement plan, earnings are reinvested and taxed only when you take money out of the plan. The income earned in the 401(k) plan is tax deferred.
A quick word about ordinary losses: It's possible for an investment to generate an ordinary loss, rather than ordinary income. In general, ordinary losses reduce ordinary income.
Understanding what basis means
Let's move on to what happens when you sell an investment vehicle. Before getting into capital gains and losses, though, you need to understand an important term--basis. Generally speaking, basis refers to the amount of your investment in an asset. To calculate the capital gain or loss when you sell or exchange an asset, you must know how to determine both your initial basis and adjusted basis in the asset.
First, initial basis. Usually, your initial basis equals your cost--what you paid for the asset. For example, if you purchased one share of stock for $10,000, your initial basis in the stock is $10,000. However, your initial basis can differ from the cost if you did not purchase an asset but rather received it as a gift or inheritance, or in a tax-free exchange.
Next, adjusted basis. Your initial basis in an asset can increase or decrease over time in certain circumstances. For example, if you buy a house for $100,000, your initial basis in the house will be $100,000. If you later improve your home by installing a $5,000 deck, your adjusted basis in the house may be $105,000. You should be aware of which items increase the basis of your asset, and which items decrease the basis of your asset. See IRS Publication 551 for details.
Calculating your capital gain or loss
If you sell stocks, bonds, or other capital assets, you'll end up with a capital gain or loss. Special capital gains tax rates may apply. These rates may be lower than ordinary income tax rates.
Basically, capital gain (or loss) equals the amount that you realize on the sale of your asset (i.e., the amount of cash and/or the value of any property you receive) less your adjusted basis in the asset. If you sell an asset for more than your adjusted basis in the asset, you'll have a capital gain. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $15,000, your capital gain will be $5,000. If you sell an asset for less than your adjusted basis in the asset, you'll have a capital loss. For example, assume you had an adjusted basis in stock of $10,000. If you sell the stock for $8,000, your capital loss will be $2,000.
Schedule D of your income tax return is where you'll calculate your short-term and long-term capital gains and losses, and figure the tax due, if any. You'll need to know not only your adjusted basis and the amount realized from each sale, but also your holding period, your marginal income tax bracket, and the type of asset(s) involved. See IRS Publication 544 for details.
· Holding period: Generally, the holding period refers to how long you owned an asset. A capital gain is classified as short term if the asset was held for a year or less, and long term if the asset was held for more than one year. The tax rates applied to long-term capital gain income are generally lower than those applied to short-term capital gain income. Short-term capital gains are taxed at the same rate as your ordinary income.
· Marginal income tax bracket: Marginal income tax brackets are expressed by their marginal tax rate (e.g., 15 percent, 25 percent). Your marginal tax bracket depends on your filing status and the level of your taxable income. When you sell an asset, the capital gains tax rate that applies to the gain will depend on your marginal income tax bracket. Generally, a 0 percent long-term capital gains tax rate applies to individuals in the 10 or 15 percent tax bracket, while the long-term capital gains of individuals in the other tax brackets are currently subject to a maximum rate of 15 percent.
Type of asset: The type of asset that you sell will dictate the capital gain rate that applies, and possibly the steps that you should take to calculate the capital gain (or loss). For instance, the sale of an antique is taxed at the maximum tax rate of 28 percent even if you held the antique for more than 12 months.
Using capital losses to reduce your tax liability
You can use capital losses from one investment to reduce the capital gains from other investments. You can also use a capital loss against up to $3,000 of ordinary income this year ($1,500 for married persons filing separately). Losses not used this year can offset future capital gains. Schedule D of your federal income tax return can lead you through this process.
Getting help when things get too complicated
The sale of some assets are more difficult to calculate and report than others, so you may need to consult an IRS publication or other tax references to properly calculate your capital gain or loss. Also, remember that you can always seek the assistance of an accountant or other tax professional.
Starting in 2013 -- new Medicare contribution tax on unearned income may apply
Beginning in 2013, high-income individuals may be subject to a new 3.8 percent Medicare contribution tax on unearned income (the new tax is also imposed on estates and trusts, although slightly different rules apply). The tax is equal to 3.8 percent of the lesser of:
· Your net investment income (generally, net income from interest, dividends, annuities, royalties and rents, and capital gains, as well as income from a business that is considered a passive activity), or
· The amount of your modified adjusted gross income that exceeds $200,000 ($250,000 if married filing a joint federal income tax return, $125,000 if married filing a separate return)
So, effectively, you're subject to the additional 3.8 percent tax only if your adjusted gross income exceeds the dollar thresholds listed above. It's worth noting that interest on tax-exempt bonds is not considered net investment income for purposes of the additional tax. Qualified retirement plan and IRA distributions are also not considered investment income.
Updated 12/7/2011
