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September 09, 2010

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Department of Insurance

Taxing Social Security Benefits: Deferred Annuities and IRAs Can Help
By Margaret A. Kruse
Product Tax Counsel
The Integrity Companies

Broker/dealer and agent only

Did you know that the more income you have, the more your Social Security benefits are taxed? If your income is low, none of your Social Security will be taxed. But people with moderate to high incomes can have 50%-85% of their benefits taxed. Interest earnings in deferred annuities or traditional IRAs, or income distributed tax-free from Roth IRAs, can help keep your taxable income low. Lower income can reduce or eliminate the taxes on your Social Security benefits.

To figure out whether your Social Security is taxed, your income (as defined later) must reach a threshold level:

If your income is less than $32,000 for joint filers ($25,000 for singles), you have not reached the threshold; none of your Social Security will be taxed.
When income falls between $32,000 and $44,000 for joint filers ($25,000 to $34,000 for single), up to 50% of your Social Security may be income taxed.
Above $44,000 for joint ($34,000 for single), up to 85% of your Social Security benefits may be income taxed.
Married filing separate have a threshold of $0 if the couple lived together at all during the year. If they lived apart the entire year, they have the same thresholds as singles.

The actual computation of the amount of Social Security to include in your taxable income is complicated. You can see the calculation on the Social Security worksheet found on p. 28 of the IRS instructions for the 2002 Form 1040. (You can find the 1040 Instructions on the IRS website: www.irs.ustreas.gov.)

If some of your Social Security is included, the tax you owe on the benefits will depend on your marginal bracket(s). Suppose you receive $10,000 of Social Security this year. Your income is so high that 85% of the benefits ($8,500) will be included in your income. How much tax you pay depends on your marginal bracket. If the $8,500 all falls in a 27% bracket, then the tax on your Social Security benefits will be $2,295.

So what makes up the income to reach the threshold? The IRS worksheet gives the details. For purposes of reaching the threshold, most income is included, but only half of your Social Security benefit for the year. Surprisingly, even municipal bond interest is counted, even though it otherwise is tax-exempt. Interest still deferred inside an annuity, IRA or retirement account is not included, nor are Roth qualified distributions. Therefore, some conclusions:

While municipal bond income remains tax-free, it can have the unexpected effect of raising income taxes. This happens when muni bond interest pushes total income over the Social Security thresholds.
On the other hand, having income deferred through annuities, IRAs or retirement accounts will not add to your income, and won't increase the amount of Social Security which is taxed. If you don't need distributions to cover expenses, these deferred vehicles may help keep tax on Social Security benefits lower for the year.
Qualified Roth distributions are a two-fer: not only are they tax-free, but they will not be added to income for purposes of determining your Social Security thresholds.

Example: Suppose you are a joint filer and you had $10,000 of muni bond interest, $5,000 of Social Security and $27,500 of other income. This is enough to push you over the $32,000 50% threshold:

  $27,500 other income
+$10,000 muni bond interest
   +$2500 ½ of Social Security
   ____________
=$40,000 income, which is $8,000 over the $32,000 50% threshold

This subjects 50% of your Social Security to tax (i.e., $2,500 of your $5,000 benefit is included in taxable income).

What would change if, instead of the municipal bond investment, you had invested in a deferred annuity or a Roth IRA? The $5,000 earned on the deferred annuity would not count as taxable income until you took it out. And if you had used the Roth IRA, the $5,000 of Roth income would be income tax-free whether you accumulated it or you took qualified distributions. Bottom line: you would not reach the 50% threshold:

   $27,500 other income
         + $0 Roth distributions or deferred income
  + $2,500 ½ Social Security benefits
  ____________
=$30,000 income, which is $2,000 under the $32,000 50% threshold

None of your Social Security would be taxed.

The impact of this technique is even greater when you can avoid 85% inclusion at higher income tax rates.

While Roth income can always remain tax free, deferred annuity, IRA or qualified retirement plan income will be subject to income tax at some point. The tax will occur when you (or your beneficiaries after your death) take distributions.

Here are some other things you can do to reduce income to have less of your Social Security taxed:

Reduce taxable interest and dividends. Again, deferring through an annuity can help.
Don't over-withhold on state income tax-tax refunds from the state will be added to your income and could push you up over a threshold.
Accelerating capital losses can reduce your income - currently, you can deduct up to $3,000 of net capital loss against your ordinary income.
Taxable IRA distributions are added to income. Therefore take only the Minimum Required Distribution. Also consider if it makes sense to convert to a Roth prior to receiving Social Security.
If you are under 70 ½ and eligible to make a deductible traditional IRA contribution, the deduction can reduce your income by up to $3,500. If you are still working, consider contributing to a 401(k), 403(b) or SIMPLE or 457 plan offered by your employer (you should be able to contribute even after age 70 ½). This could reduce your income by as much as $14,000. Remember, though, that your earnings will push up income.
If you are self-employed, you can reduce income by deducting ½ of self-employment tax, self-employment insurance and any self-employed retirement plan contribution you have. Again, your self-employed earnings will add to your income.
In general, time income and adjustments to stay under thresholds for more years.

Note: it does not help to increase "below the line" itemized deductions such as charitable contributions, mortgage interest, property taxes or medical expenses. The thresholds are based on modified adjusted gross income, before you take itemized deductions.

The rules on taxing Social Security apply not just to retirement benefits, but Social Security disability benefits as well. If your Social Security disability benefit is reduced because you receive worker's compensation, you include the worker's comp as Social Security when calculating how much of your Social Security benefit is taxed.

The Social Security thresholds are listed on Integrity Life's annual Tax Reference Sheet. Call your Integrity Sales representative for a copy.

This material reflects Integrity Life Insurance Company's understanding of the current federal tax laws and contains information of a general nature. The information provided is not intended to be legal or tax advice. Integrity suggest you or your clients consult a tax advisor or attorney as to the applicability of this material or a specific situation.

For more detail on Integrity Life Annuities please contact the Integrity Life Sales desk at 800-666-7040 to obtain a prospectus. Products are issued by Integrity Life Insurance Company, Cincinnati, Ohio. Products sold in New York, Vermont and New Hampshire are issued by National Integrity Life Insurance Company, Goshen, NY. All products distributed by Touchstone Securities, Inc. Cincinnati, OH member NASD/SIPC.

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