Annuity Income and Tax on Social Security

A reader sent in a question about how annuity income could affect his tax on Social Security benefits: “George, I’m considering purchasing an immediate annuity. I’m 81 years old and in excellent health. The funds would come from my IRA, so I would not receive the tax break from the exclusion ratio. “I am considering this purchase because I’m currently drawing out about $1,400 a month from my IRA, or about $16,800 a year. This is affecting the tax on my Social Security income. What I don't know is if the payout from the immediate annuity would be included in the calculation of income in terms of calculating my Social Security tax? “I am aware that I’d have to pay ordinary income on the funds received. The payout on the annuity is $517 per month for life, so it reduces my income by about $10,000 a year. The question is: Will I have to include the annuity income in my Social Security calculations. “Thanks so much for any thoughts you have on this matter.” My answer: “You are correct in saying that the annuity would not qualify for the exclusion ratio since the money is coming from your IRA. And since all of the annuity’s income is taxable, it must be included in the calculation to determine how much of your Social Security benefits are taxable.” Many boomers entering retirement are not aware that their Social Security benefits could be taxable. This can apply if you are single and earning at least $25,000 a year or married and earning $32,000 or more. Earnings include one-half of your benefits and all other income, including tax-exempt interest. So before you make the decision to start taking Social Security, make sure you understand how much of those benefits will be taxable. For information, go to IRS Publication 915. Best wishes, George P.S. I’m now on Twitter. Follow me at http://twitter.com/efinancialwrite for frequent updates, personal insights and observations on how to have a healthy retirement.

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Have You Ignored this Piece of Your Retirement Plan?

Do you keep up-to-date with your retirement plan? I’m speaking of plans like your 401(k) and IRA. Hopefully you’re on top of the investments in the accounts and not just tossing unopened, quarterly statements in a dresser drawer. There is, however, an aspect of these plans that even many savvy investors completely ignore after the accounts are opened. And that is: What happens to the money when they die. Will yours go to your spouse … an ex-spouse … your children? And if no one is named, it could end up in your estate. Then the state will hand it out as they see fit. That’s why the account beneficiary form is one of the most important forms you should review regularly. Particularly, if there has been a big change in your life. And the best part is that unless you need special legal advice, it doesn’t cost you a single penny to make changes. For instance, have you recently divorced, gotten married or both? Imagine the turmoil if your ex-spouse inherited your IRA instead of your new bride? I saw that happen to a friend on mine ... He went through a long and tumultuous divorce. Then got remarried. He changed his will and trust documents, but didn’t bother with his IRA, which was in the seven figure range. Apparently he though it was covered through the will or trust. Poor guy died. Guess who ended up with the IRA? His ex-wife and her children from a prior marriage! His new wife took the issue to court … and lost. What about children or grandchildren, any new ones? Or have any become compulsive shoppers and now have bill collectors hounding them day and night? You might have to set up special provisions for them, such as a spendthrift trust, so creditors can’t get at any of their inheritance. Have any of your beneficiaries died? If so, you should name replacements. Maybe now you have a favorite charity you’d like to help out. Updating your IRA beneficiary form to leaving it a piece of your IRA is a simple way to accomplish that. Do you have minor children named as beneficiaries? Who will receive the money on their behalf? Is that person still available? And suppose one of your adult children dies before you. Does your beneficiary form use the “per stirpes” language, which passes the deceased child’s portion to his or her children? Or will it be divided among your other children? You might want to double-check the documents. What about estate and income taxes. IRA and other retirement plan assets will be included in your taxable estate. And estate taxes are due nine months after you die. Have you discussed with your beneficiaries how to come up with the cash to pay those taxes? Income taxes can often be spread out over the beneficiary’s life expectancy. However, your beneficiaries must know how to take advantage of this provision. Otherwise, they could face a huge tax bill. Finally, does anyone know where you keep important papers, like your will and deed for your home? If so, you better put a copy of the beneficiary form there, too. Nothing is static in today’s world. Not the tax laws, not the investments inside your retirement accounts and certainly not your personal situation. So for your love ones’ sake, be sure to keep on top of your beneficiary designations. Best wishes, George

Five Questions to Ask Before You Convert

There’s a good chance you’ve been given a pitch to convert. No, not to some off-the-wall religion or cult, but by your financial advisor, insurance agent or broker to move your traditional IRA to a Roth IRA. And this can be a good thing ... After all, once your money hits the Roth you and your heirs will never have to worry about paying income taxes on it again. Plus unlike a traditional IRA, you won’t have to hassle with required minimum distributions beginning at 70½. So what’s not to like! One obstacle is that you’ll have to pay income tax on the amount you convert. That means, for example, coming up with $25,000 on a $100,000 conversion assuming you’re in the 25% tax bracket. But if you think you’ll be in a higher bracket when you retire or rates will go up in the future, paying the tax now could be a good choice. Think about your kids, too. Will they be in a higher bracket years down the road? Also, where will you get the money to pay the tax if you do convert? Your IRA custodian will ask if you want tax withheld from the distribution. This is generally a bad idea because you’ll end up paying taxes on those dollars, too. Moreover, it reduces the amount available to grow tax-free inside your Roth. A much better idea is to use money from outside your traditional IRA, such as from a money market or savings account. The second obstacle is dealing with the unknown ... How much do you trust Congress? Do you think they’ll revoke the tax-free status of Roths after they pocket the tax dollars you’ll fork over when you convert? The $1.4 trillion deficit they’ve rung up for 2010, plus $109 trillion Washington has promised to pay in Social Security and Medicare benefits, should be a clear warning that higher taxes are ahead. Already, House Majority Leader Steny Hoyer (D-MD) told reporters that raising taxes on middle class families will be necessary to tackle the debt. So where does this leave you if you’re thinking about converting? Consider these five points … 1. Do you have non-IRA money available to pay the taxes for the conversion?

2. Will your tax bracket be higher when you retire?

3. Is your beneficiaries’ tax bracket higher than yours?

4. Do you think Congress will raise income taxes in the future? What about your state taxes?

5. Do you think Congress will double-cross voters and tax Roths? If you answer “yes” for the first four questions, you’re probably a good candidate for a Roth conversion. It could pay off big time for you and your love ones. And if you answer “yes” for #5, then a Roth and any other tax-favored investment might be off the table for you. Best wishes, George

The Debt Clock Keeps on Ticking

Remember the Timex ad where John Cameron Swayze said: “Timex — Takes a Licking and keeps on Ticking.” Well, the folks at Timex have a long way to go if they want to catch up with our officials in Washington. Take a look at the U.S. Debt Clock. Besides the swelling national debt, you’ll find interesting facts such as how much we’re spending on Social Security, debt per citizen and income per family. Watching all the clocks tick away is a sight to behold ... Do you know, for instance, the personal savings for every citizen is only $1,100? Do you know that our Medicare liability is almost $76 trillion? How about the number of food stamp recipients? More than 41 million. But don’t let the ever-changing numbers depress you. Other than getting rid of all incumbents, there’s nothing you can do about them. Instead, study them ... memorize a few of the choice ones. Then imagine how you could use those goodies to impress your friends and family at the upcoming July 4 picnic. Best wishes and happy clock watching! George

Make Your Nest Egg Last Longer Without Shortchanging Your Love Ones

Immediate annuities are getting a lot of publicity lately. And it’s the good kind … First, a quick background on immediate annuities: You put a lump sum of money into an immediate annuity contract, and the insurance company guarantees you’ll receive a fixed income for the rest of your life. When you die, the payments stop. The size of the payments depends on the amount you deposit and your age. The older you are, the higher the payments since the insurance company is betting you won’t beat their life expectancy tables. There are other versions available that pay for a set number of years and options that will make sure a survivor, like your spouse, continues to get an income. But let’s just stay with the basic annuity today. For years, immediate annuities were portrayed as low-yielding, boring investments. Stocks and real estate left annuity returns in the dust. Then the dot-com bubble broke. Then real estate blew up. And most recently, financials have taken a bloody beating. Through it all, though, annuity holders have been getting their checks month, after month, after month. And now annuities have become the belle of the ball! Even President Obama has endorsed the importance of an immediate annuity. Without saying so, I imagine he realizes that Social Security will spend more than it takes in by 2016, and will be broke by 2037. Plus he must know that pension plans are on their way out. So it’s up to you to do everything you can to fill the gap that the government and your employer cannot. And an immediate annuity could be just what you need. For instance, you might consider an immediate annuity for paying fixed expenses, like your homeowners insurance, real estate taxes and utilities. Suppose that comes out to $1,000 per month. According to immediateannuities.com, a 65-year old male in Florida would need to come up with $158,019 to guarantee he’d get $1,000 a month for the rest of his life. Granted, that’s a hefty chuck of change. But that $1,000 will come in regardless of what’s happening to stocks, bonds, real estate or gold. Plus it’ll continue as long as he lives … even if that’s another 65 years! If you like this idea so far, great. Yet there’s a potential problem: Your love ones. Because once you pay for the annuity contract, the money belongs to the insurance company. There is, however, a way to make sure your need for a safe source of income doesn’t leave your heirs out in the cold … and that’s with life insurance. You could use part of the annuity income to buy an insurance policy with a death benefit equal to the amount you put into the annuity. Another idea is to liquidate a poor performing investment you’ve been holding forever, and buy a single-premium life insurance policy. There are other strategies you can use, too. So it’s a good idea to get with a financial planner or an insurance agent who can help you find what will work best for you and your nest egg. Best wishes, George

Do You Have Too Much Of Your Retirement Nest Egg In Your Employer’s Stock?

Many companies allow employees to purchase company stock inside their 401(k) plans. What’s more, company contributions are often in the form of company stock.

This can be an easy sell. After all, workers understand the industry, have a handle on what’s going on within the company and may even know the people running the organization. Plus it gives them a vested interest in the company where they spend 40 hours or more working each week.

But having too much of your retirement assets invested in company stock can be a risky strategy. Just ask anyone who had fallen in love with company stock while working for Enron or Worldcom when the firms collapsed. In fact, 57.73% of employees' 401(k) assets were invested in Enron stock as it fell 98.8% in value during 2001.

However, if you want to sell the company stock and reinvest the money in other options your 401(k) offers, there are often restrictions ...

For instance, some companies require employees hold employer-matched stock until they reach a certain age, or until a specific date. Or when administrative tasks are being performed, there could be a lockdown or blackout when account activity is frozen.

Either of these examples could spell disaster if the stock is taking a nosedive and you want to get out.

The good news is that effective May 19, 2010, for plan years that begin on or after January 1, 2011, employees will have more freedom to diversify out of company stock.

The new IRS rule requires that employees be allowed to move out of their company’s stock as often as they can move out of other investments offered in their 401(k) plan. This must be no less frequently than quarterly with at least three alternative options.

How much is too much company stock? Well, everyone’s tolerance for risk is different. But if the stock makes up 10% to 20% of your total investment portfolio, you might want to take a closer look to make sure you’re comfortable with the risk.

And at least now your ability to move out of it will be easier.

Best wishes,

George

Frank Is Considering Secondary Annuities

I got an e-mail from Frank in Minnesota that touched on a topic I never really thought about. Dear George, I am researching information about the Secondary Annuity Market, but from a buyer's perspective. I am 66 years old, and ready to invest a healthy chunk of my assets into immediate lifetime annuities, for both me and my wife (age 64). Some of the assets are from IRA accounts, and some from our joint account. I've received some quotes and did spreadsheet projections to 2046 (her 100th birthday). She comes from a family that has old age genes. Her folks are still alive. Her grandparents lived into mid 90's. She has a good chance to reach the century mark. I, on the other hand, was not so blessed with the same genes. If I live to 70, I will have beat the Cardiologist's prediction by 5 years. Anyhow, while researching my investment options, I stumbled upon the Secondary Annuity Market. I was most interested in those secondary annuities that pay on a regular monthly basis, rather than lump sums. I found some examples of payouts and applied them to a spreadsheet, and found some interesting results. For example, the secondary payouts may be more generous than current annuity quotes. And, some of the payouts result in a greater income stream while she is in her 70's-80's, versus receiving consistent income until age 100. After doing some more research, I found that I could not use IRA monies for the Secondary Market. Also, I found an article about State Insurance Commissioners opinions that Insurance companies are not bound by payments to Secondary Annuity owners, and can choose to opt out (that is very troubling!!) of future payments. So, bottom line is ... what are the pros and cons of Secondary Annuities from a buyer’s perspective? Any helpful information? Thank you for your consideration. And here’s my reply … Hi Frank, I've seen these advertised on TV, with people screaming "I want my money now!" but have never really researched them. I can see how you could get a higher return since the desperate sellers what a lump sum instead of ongoing payments. But I believe the issue is: Who is behind the payments? I checked out your allegation that the issuer could back out of the deal. And sure enough, you’re right! In fact, on February 22, 2010, the Interstate Insurance Product Regulation Commission, composed of the insurance regulators from 35 states and Puerto Rico, voted in favor of a uniform provision that would allow insurance carriers to terminate at their discretion guaranteed living and death benefits in the event of a change in ownership or assignment. To me, that’s downright scary! Think safety here, Frank. And that's the concept behind immediate annuities. In other words, a steady stream of income you and your wife cannot outlive. They let you sleep at night. For the few extra bucks you'd get each month, it doesn’t seem as though the secondary market is worth the risk. Have you looked into immediate annuities with joint benefits? That way when one of you dies, the other continues to get an income. Also, considering the low interest rate environment we're in now, you might think about only putting a small portion of your money into an immediate annuity. Then a little more next year, and more the year after that.

With the ballooning debt the U.S. is facing, Treasuries and all interest rates are almost guaranteed to rise. And by buying the annuities along the way, your income should rise, too. Good luck! If you’re looking for a reliable income that you can’t outlive, immediate annuities could be the answer. Be sure to do your research, though. And double-check everything anyone tells you. Because, like Frank, you may discover some important points once you peel back the onion. Best wishes, George