Up to 85% of your Social Security Benefit May Be Taxed

There is a popular misconception that social security benefits are received tax free. Unfortunately, this is not the case. A large portion of your social security benefit can be taxable at ordinary income tax rates. The higher your retirement income, the greater the percentage of social security benefits that are subject to taxes.

A tax on social security benefit is triggered by certain income levels, called a threshold. There are two threshold tiers and they a applied as follows:

Retirement income sources that pump up your threshold income include: interest income from bonds, CD’s and other sources, dividends, income from real estate, real estate trusts, partnerships, pensions, profit sharing plans, non-qualified deferred compensation arrangements and other investment income. Even municipal bond interest, despite its tax free nature, can push income levels into social security tax territory. On the other hand, interest and capital gains that compound tax free in a 401k, IRA, Roth IRA, deferred annuity, ILIPP (Indexed Life Insurance Private Pension) or FLIPP (Fixed Life Insurance Private Pension) has no effect on the social security threshold.

Accumulations inside a 401k or an IRA are not reportable and are social security tax neutral. However, distributions from these types of plans increases taxable income and can trigger taxes on social security benefits. Distributions from deferred annuity may have a lesser impact on the threshold income, because only a portion of some distributions are taxed. A deferred annuity account consists of interest that has not been taxed and after-tax contributions to principal. Distributions of interest add to threshold income, but withdrawals of principal do not. Since annuities have two or more tax distributions options, they do provide some freedom to manage their impact on threshold income.

The following do not impact social security taxation thresholds, either during the accumulation phase or the distribution phase.

	Roth IRA
	ILIPP (Indexed Life Insurance Private Pension)
	FLIPP (Fixed Life Insurance Private Pension)

Individuals who arrange their retirement portfolios with the above information in mind will reduce some or all of their social security benefits they have paid for their entire working life. Those who do not will overpay their taxes and reduce their spendable income at retirement.

Example: Jake and Jerry Similar are twins. They were born on the same day, graduated from the same college, lived in similar houses in the same neighborhood and always bought identical cars. They each had two children and owned a business together for 35 years. The day they retired, they sold their business for a net after-tax profit of $550,000 each. Since their salaries during their working years had been equal, their pension income and social security benefits were also equal.

Jake’s brother-in-law was a stock broker and advised Jake to use his $550,000 to purchase a conservative portfolio of stocks and bonds. Jerry’s brother-in-law was an insurance agent and financial planner. He set set Jerry up with a tax deferred annuity. By coincidence, both brothers earned 6% on their $550,000 nest egg.

Since Jake’s interest and dividend income was subject to income taxes it was entered on lines 8a and 9a of his 1040. This made the amount not only taxable, but also triggered a tax on Jake’s social security benefit. Jerry on the other hand, received $33,000 in interest, but this was credited inside the deferred annuity. It was not taxable, was not listed on the Jerry’s tax return. It therefore, did not trigger any taxes on Jerry’s social security benefits. One year after retirement, Jake and Jerry’s income position, compares as follows:

For additional information _ ??? links?? - Worksheet used to calculate the percentage of social security that will be taxed.
Form 1040 and 1040A.

*These are hypothetical comparisons, solely intended to illustrate the advantage of tax deferral. It does not represent any particular investment or savings account; nor is it intended to recommend any specific course of action.

**Tax deferred annuities frequently carry a surrender charge of a specified duration. This surrender charge generally declines over a number of years. When selecting a tax deferred annuity, please consider the effect of this surrender charge on your planning. Withdrawals from a tax deferred annuity impose a tax penalty of 10% on distributions prior to age 59 1/2, unless those distributions meet certain extended payout requirements.