Retirement Income Blog

Immediate annuities pay a regularincome and because the payments are based on age, it only makes sense for people age 60+ to use these vehicles (the higher the age when you invest, the higher the payment–see the immediate annuity calculator).  The senior tax break is that IRA considers some of the payment return of principal (untaxed) and some of the payment interest (taxed).  For an investor age 60+, 60% or more of each payment will not be taxed (unless the investor exceeds their life expectancy in the case of a life annuity).  The fact that IRS excludes a portion of the payment from tax is a tax break for seniors.

Social Security Income is Taxed on  Favorable Basis

While working people pay tax on their social security income, seniors pay tax on only part their social security income.  The portion of social security income that is taxed can vary from 0% to 85%, based on the senior’s total amount of income. Since only people age 62 receive social security retirement benefits, we can refer to this as a tax break for seniors. Retirees can actually manage their finances to reduce taxes on their social security benefits by moving money from assets that increase total income (CDs, bonds, tax free bonds, savings bonds) to deferred annuities or immediate annuities, some or all of the income form which does not appear on the tax return.  These investments lower the total income appearing on the tax return and thus the percentage of social security income subject to tax. 

Control the pace of IRA distributions

People age 70 1/2 must take distributions from their IRA, but above a minimum required amount, they can decide how much to take.  The less they take, the less tax is paid today.  Over the last 10 years, the government has reduced the minimum amount that needs to be taken creating a tax break for seniors. As a senior, you can manage your finances to take just the minimum required IRA distribution and using non-IRA assets for living expenses.

Select Which Funds to Use First and Reduce Your Taxes

If you spend $ of your IRA money, you may pay up to 35% tax on that IRA withdrawal.  But if you spend $1 from your savings account, you pay no tax to withdraw that money.   Therefore, because as a senior, you live off different parts of your nest egg, you can control your tax bill in a way that working person living from salary cannot.

 Long Term Care Insurance-two levels of tax breaks for seniors

The federal government wants you to have long term care insurance so they provide two senior tax breaks as an incentive (see estimated costs using the long term care calculator).  Since the average buyer of long term care is age 60+ any tax breaks regarding long term care are essentially tax breaks for seniors. Although not many people qualify for the first tax break, to the extent your out of pocket medical expenses and health insurance premiums exceed 7.5% of your adjusted gross income, you can deduct that excess as an itemized deduction on our tax return.  There is a limit to how much can be deducted but that limit increases with age–in effect an age-based tax break for seniors.

Want to know more about tax breaks for seniors? Click on the booklet to get your copy.

Tax Breaks for Seniors

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While most tax rules and tax rates apply equally to all taxpayers, there are some tax law provisions that are particularly senior tax issues because seniors are the ones most affected.  Below are a few senior tax issues and an offer to get a more comprehensive booklet if interested.  Some minor tax planning in retirement can result in big saving as you shall see.

Immediate Annuities Help Retirees Reduce Tax
Immediate annuities pay a monthly income and few people below age 60 buy immediate annuities as younger people usually derive their income from working, not from investments.  The senior tax issue here is the exclusion ratio.  For every immediate annuity payment, a significant portion is not subject to tax.  This exclusion ratio means that from each payment, a retiree has more spendable income than from alternate investments.

Immediate or Deferred Annuities can reduce the senior tax on social security income
Since people age 62 and over pay tax on social security income, we can refer to this as a senior tax. The ways to reduce income tax on your social security income is by moving money from items that increase the income tax on your social security income negatively (CDs, bonds, tax free bonds, savings bonds) to deferred annuities or immediate annuities.  Since none of the reinvested interest from a deferred annuity appears on your tax return, the income on your tax return is lower and thus, this will reduce or eliminate tax on your social security income.  This senior tax is also impacted favorably by the ownership of immediate annuities because a large portion of the monthly payments are excluded from reporting on your tax return making immediate annuities a superb source of supplemental retirement income.

Slow down IRA distributions
Since only people that have reached age 70 1/2 must take IRA distributions, the taxation of these withdrawals is certainly a senior tax issue.  Some retirees may be taking more than the IRA required mandatory distribution.  Even if you need the income for living expenses, you will lower your tax by reducing your IRA withdrawals to the IRS required minimum and spending principal from your non-IRA assets to live on.  Although the spending of principal is taboo for many retirees, there is no difference between principal and income. It’s all green money and this recommendation will reduce the senior tax on your IRA.  This dovetails with our next senior tax issue.

Spend your regular money first
The order in which you spend your different pots of money in retirement affects your taxes.  As hinted above, if you take $1 from your IRA, you only have say 70 cents to spend because you must pay income tax on the IRA withdrawals.  However, if you withdraw a dollar form your savings account, whether its interest or principal, this money has already been taxed and you have a full dollar to spend.  So an important general senior tax recommendation is to use up your after-tax dollars before using your pre-tax dollars.

Long Term Care Insurance
Last, consider that the federal government will subsidize your cost for long term care insurance.  Since the average buyer of long term care is age 62 and the government allows a larger deduction based on higher age, this is specifically a senior tax issue.  Although not many people qualify, to the extent your out of pocket medical expenses and health insurance premiums exceed 7.5% of your adjusted gross income, you can deduct that excess as an itemized deduction on your tax return.  If you pay a long term care premium, that can be added to your out of pocket health expenses thereby making it potentially deductible.  You can read more details on utilizing these senior tax benefits in the booklet below.  Click on the booklet and get your free copy.

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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.

You can learn  more about retirement annuities and tax planning for retirees at our main web site.

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