By Jack Krumeich-Miller, E.A. | December 22, 2018

As the year comes to a close, there is still a window of time to make your last tax moves to prepare for filing season and get the most from your tax situation.  There are five specific retirement tax planning tips this article will focus on:

1. Itemizing Deductions has changed for 2018 – The new standard deductions increased because of the Tax Cuts and Jobs Act.  The standard deductions are now $12,000 for single filers and those married filing separately.  $18,000 for Head of Household.  $24,000 for those married filing jointly.  There are also limitations and removal of what could be itemized.  SALT deduction (State and Local Tax) has a limit of $10,000.  Unreimbursed employee expenses and other miscellaneous deductions are not available anymore.  You can still deduct medical expenses that exceed 7.5% of your AGI (adjusted gross income) for 2018 and 10% of your AGI in 2019 and charitable contributions to qualified organizations.  With that in mind, it is harder for these deductible expenses to exceed the standard deductions.  A strategy called “bunching” can be used to bunch unclaimed deductions from prior tax years or future years and deduct them all in one tax year where you know it will be enough to exceed the standard deduction.  Bunching works specifically by paying ahead of time or waiting till the year you want to deduct them to pay them.  If you have a medical expense in 2018, and you wait to pay it until 2019, you can deduct it in 2019.  If you want to make your 2019 charitable contributions in 2018, you can deduct them in 2018.
2. If you are 70 ½ or older and have RMDs (Required Minimum Distributions) on your traditional IRA, you can reduce or eliminate them by donating a portion of them directly to any qualified charitable organization.  This is called a Qualified Charitable Distribution. (QCD)  The portion of your RMD that is used for the QCD is not included in your income and it is also not included in your itemized deductions.   This can provide nice tax savings. You can also donate more than your RMD this way to charity. In fact, a person is allowed to donate from their IRA as a QCD up to $100,000 annually!
3. If you have any concerns about not paying enough each quarter in estimated taxes, or didn’t withhold enough in your paychecks, you can take an IRA distribution s to use toward the estimated taxes you will owe in 2018.   This strategy works because any money withheld from an IRA distribution and sent directly to the IRS as a tax withholding is considered received equally throughout the year even though the IRS receives it in one lump-sum. It works by requesting a distribution for the amount you think you need to pay in estimated taxes for 2018 and have your IRA custodian send 100% of the distribution to the IRS as a tax withholding.  This process could eliminate any potential underpayment of estimated tax penalties even if you missed a quarterly payment during the tax year.
4. If you see yourself in a higher income tax bracket for 2018 than you would be in 2019 because of any year-end bonuses, see if you can postpone the bonus income payout until 2019.  On the flip side, if you see yourself in a lower tax bracket in 2018 than you would be in 2019, it may be beneficial to accelerate your income to be paid out in 2018 where possible.
5. Start planning for next year’s taxes.  Identify any benefits you may qualify for or that are provided by your employer (401(k), HSA, FSA, etc.) which you can take advantage of to potentially lower your taxable income in 2019.  You can see what tax bracket or tax situation you have for 2018 and decide what actions to take to potentially change your tax situation to be more favorable in 2019.

If you have any questions about these and other tax planning tips and tricks you have read or heard about, contact our office and we are happy to discuss them with you.  There are several changes in how taxes work because of the Tax Changes and Jobs Act, and we can help guide you through them to make sure you have the best tax situation available to you.  And remember, we are continuing to bring on additional clients for tax preparation services so if you would like us to prepare your taxes please let us know!

By Justin Fundalinski, MBA | June 21, 2018

In a previous article I discussed in detail the intricacies of how Social Security gets taxed. In some cases no Social Security income is taxable while in others up to 85% of Social Security income is taxable. Because of the unique way Social Security income phases into taxation, there is a “window” when every additional dollar from other income sources drags more Social Security into taxation. During this window, since every additional dollar of income creates more taxable income (in the eyes of the IRS), the effective tax rate on this other income sky rockets.  This effect is often referred to the Tax Torpedo and offers unique retirement planning opportunities.

How does the tax torpedo work?

Unfortunately, this is a very difficult concept to grasp, however if you think about with an example it is much easier to understand.

Remember, zero to 85% of your Social Security can be taxed, but what determines if none or some is taxed depends on how much other income you have. For this example, assume you have Social Security income and other income that is just low enough so that none of your Social Security income is being categorized as taxable income.

Now, imagine you need to dip into your IRA assets for an unexpected $1000 expense.  At this point, most people would assume that this withdrawal will simply cause them to have an additional $1,000 of taxable income; however, this is far from the truth.  Because of how Social Security phases in as taxable income, this $1,000 withdrawal from your IRA causes $500 of your Social Security to magically be taxable.  So, now instead of paying tax on $1,000 at your marginal tax rate, you now must pay tax on $1,500 at your marginal tax rate.

It gets worse too. The above example essentially dragged in 50 cents of Social Security income into taxation for every $1 of additional other income. As you add more income to the equation it will eventually hit a breakpoint where 85 cents of Social Security income is dragged into taxation for every $1 of additional income. Fortunately, the maximum 85% of your Social Security will eventually be subject to taxation and the window will close on this tax torpedo.

What will my effective tax rate be for each additional dollar of other income?

As with most things in life the answer to this question is, it depends.  It depends on what breakpoint you are at (50 cents or 85 cents of Social Security being dragged in as described above), as well as what your marginal tax rate is.  However, I can quickly summarize the effective rates depending on all these variables.

• If 50 cents of Social Security is being dragged in for every dollar of other income this will increase your tax rate by 50%. That is, if your marginal tax bracket is 0%, 10%, or 12% then each dollar of new income will now be taxed at 0%, 15%, 18%, respectively.
• Similarly, if 85 cents of Social Security is being dragged in for every dollar of other income this will increase your tax rate by 85%. That is, if your marginal tax bracket is 0%, 10%, 12% then each dollar of new income will now be taxed at 0%,19%, 22%, respectively.

Yikes! It is very possible to pay a 22% tax on an IRA withdrawal when you are in the 12% bracket.  How can this be fair?  Think about it like this, Social Security is still tax advantaged, however, it gets ugly during the window of income when these benefits get phased into taxation. It’s better to have tax advantaged income than 100% taxable income, right? Also, armed with this knowledge a savvy pre-retiree or early retiree can potentially take advantage of how these tax rules work.

How can I plan around the tax torpedo?

There are many ways to plan around the tax torpedo.  For some, there maybe minimal opportunity and those people simply must deal with the fact that 85% of their Social Security will be taxed. For others, a strong and disciplined IRA distribution and Roth conversation strategy coupled with appropriate Social Security claiming strategies can save thousands in taxes as well as increase the amount of tax advantaged income generated from Social Security.  If you would like to discuss in more detail how the tax torpedo could affect you personally, please reach out to our office.

By Justin Fundalinski, MBA | April 20, 2018

With the new tax law doubling the standard deduction it is going to be much harder to itemize your tax deductions. Unfortunately, for those who give to charities this change may cause their charitable gifts to be far less valuable from a tax prospective. However, there is an excellent way to give to qualified charities as well as reduce your taxable income if you are over 70½. If you haven’t already, it’s time to start making Qualified Charitable Distributions (QCDs) from your IRA.

What is a QCD?

Technically, a QCD is a direct transfer of IRA funds payable to a qualified charity.  Less technically, it is a charitable donation that is paid from your IRA account.

What are the benefits of a QCD?

QCDs come with enormous tax benefits:

• First, they are distributions from your IRA that are completely tax free. The “deduction” for

a QCD is taken on the first page of your 1040. That is, your total taxable distribution from your IRA is simply reduced by the amount of your QCD.  There is no need to itemize this deduction, and there is no special schedule for you to file (simply appropriate reporting)

• Second, they count toward your Required Minimum Distribution. If you ever felt burdened by the taxation of Required Minimum Distributions this is a great way to offset those pesky taxes.
• Third, it lowers your modified adjusted gross income figures which can reduce the taxation of Social Security as well as reduce your Medicare premiums.

What are the rules for making a QCD?

There are a few guidelines that must be followed for a QCD to be eligible:

• You must be 70½ or older. That is, Required Minimum Distributions have become a part of your normal life.
• Your QCD must be made to a 501(c)(3) organization. Funds distributed directly to you and then given to charity do not qualify as a QCD. Private foundations, donor advised funds, and supporting organizations do not qualify.
• For a QCD to count towards your current year’s Required Minimum Distribution, the funds must come out of your IRA by your Required Minimum Distribution deadline. Amounts above and beyond your Required Minimum Distributions do not count toward satisfying a future year’s Required Minimum Distributions.
• The maximum annual amount that can qualify for a QCD is $100,000. This applies to all QCDs made in a calendar year, not for each individual charity. If you file taxes jointly your spouse is also eligible for $100,000 of QCDs.
• QCDs are allowed from inherited IRAs, however you must be still be over 70½ to be eligible.
• QCDs are limited to the amount that would otherwise be taxed as ordinary income. Basically, this rule excludes non-deductible/after-tax contributions that you may have made to your IRA which would be received back in a tax-free manner anyway.

What do you need to watch out for?

If you are following all the rules listed above, there is likely only one major thing to watch out for. Your IRA custodian does not report your QCD distribution in any special format to notify the IRS that you made a QCD. That said, your 1099-R will reflect the full distribution from your IRA and will show it as a taxable. It is up to you to let your tax professional know that you made QCDs so that they can report the distribution appropriately to the IRS.

If you would like to learn more about QCDs or how you make QCDs, please feel free to reach out to us directly at the office.

By Justin Fundalinski, MBA | March 20, 2018

Considering the reader base of this newsletter, I assume most reading this are attempting to be  good savers for retirement and are patting themselves on the back each year for peeling off portions of their earned income to save into 401(k)s and IRAs, all while reducing their current year’s tax bill.  I commend you for your discipline and urge you to look even deeper into the future.  As we all know the only thing guaranteed in life is death and taxes. While we can’t help you with death (perhaps my wife could as a Board Certified Palliative and Hospice Nurse Practitioner), I do think we can help reduce the tax liability you are creating for yourself in the future when you defer those taxes by saving into accounts like 401(k)s and Traditional IRAs.

What Is the Tax Void?

We have coined another term in the office called the “tax void.”  As eloquently as possible, it is defined as the period of time between retirement and age 70[1] when retirees have the most discretion over where their income sources are coming from and thus they have the most control of their tax liability.  By “where” I mean what type of account they are debiting from(qualified or non-qualified, taxable or not taxable, etc…) as well as whether or not they are deferring  income from Social Security, Pension, and/or annuities.

As an extreme example, if somebody could delay taking withdrawals from 401(k), Traditional IRAs, or other similar tax deferred retirement accounts as well as defer their taxable income sources like Social Security and pension income, then they would enjoy a temporary luxury of not having to pay any taxes between retirement and age 70. While most people don’t have the ability to have such complete discretion, most people do have some discretion and such discretion can create a tax void (although maybe not as deep as the one made in my extreme example). However, simply avoiding paying taxes during this time period is the worst choice a retiree can make because of how short sighted it is (more on that soon).

Creating a Bigger Tax Void

Creating the opportunity to have a large tax void is probably the most difficult step in this type of tax planning, but it essentially comes down to one thing – tax diversification of retirement savings.  Tax diversification simply means how one is allocated between different types of accounts based on how withdrawals will be taxed when they take distributions from the account.

For Example:

All income from a Traditional IRA will be fully taxed as ordinary income; however, income from a non-qualified account is taxed based on how much gain was taken (as well as taxes at capital gains rates), and funds from a Roth IRA or 401k are not taxed at all.  Unfortunately, because everybody does such a good job of avoiding taxes today by saving into their 401(k) and/or Traditional IRA, the vast majority of people tend not have much in the way of tax diversification later. If it makes sense from a long-term tax perspective, saving into other types of accounts such as Roth IRA’s or Non-Qualified (Taxable) accounts will enhance your tax diversification when you retire and provide the opportunity for a greater tax void.

Filling the Tax Void

As most know, we are taxed in a tiered fashion. The first chunk of taxable income is taxed at 10%, the second chunk of taxable income is taxed at 12%, the third at 22%, and so on. As I mentioned earlier, simply avoiding paying taxes during a tax void is a bad idea. Knowing which of these tiers (or tax brackets) will be filled up entirely by income that is not discretionary once you reach age 70 is very important when it comes to filling your tax void appropriately.

For Example:

If you know that your Social Security and Pension income will fill up your 10% and 12% brackets fully at age 70 then you also know that all your Required Minimum Distributions (forced distributions for tax deferred retirement accounts) will be taxed at least at 22%. Now if you know that all your withdrawals or Required Minimum Distributions from your Traditional IRA’s or 401(k)s is going to be taxed at least at 22%, it’s probably a great idea to get any money out of those accounts at a lower tax rate whenever possible. When is it possible? During the tax void!

Roth Conversion strategies combined with other withdrawal strategies make this very achievable. The effect is that you will have less money in tax deferred retirement account, causing you to have smaller Required Minimum Distributions. This in turn causes you to have less income taxed at higher rates as well as more overall tax diversification.

Conclusion

Trust me when I say that while there seems to be a lot of moving parts here this is only a 30,000-foot view of the amount of detail that must be accounted for when trying to create and fill a tax void. If you are looking for ways to ultimately decrease unnecessary Required Minimum Distributions and the associated taxes, or are just simply looking to minimize taxes in retirement please reach out to me for additional information.

[1] Why age 70? Age 70 is the longest you can delay your Social Security benefit. At age 70½ Required Minimum Distributions on tax deferred retirement accounts begin.

By Justin Fundalinski, MBA | January 20, 2018

In the most overtly sarcastic manner, I’m sure that you are all clamoring to read the new 1097 page Tax Cuts and Jobs Act. Lucky for you I have been actively reading through the portions of it that will affect most people. Below are some bullet points you can peruse through, but if you really want to get in to the dirt the full bill can be found here.

Tax Rates:

The number of marginal tax brackets was reduced from seven to…. wait a minute… seven. Although the number of brackets did not change, the numbers behind the brackets have changed through 2025. See below:

Standard Deduction:

The act drastically increased the standard deduction. This is likely where all the verbiage for “simplifying” the tax coded came from because it effectively reduces the number of people that need to itemize their deductions. (In my opinion, I never thought itemizing was all that difficult so I can’t say filing your taxes got any easier). Through 2025 the standard deduction is:
o $24,000 for married taxpayers filing joint returns
o $18,000 for heads of household
o $12,000 for all other individuals.

Personal Exemptions:

While the standard deduction went up, personal exemptions were repealed through 2025. Personal exemptions can no longer be claimed. In 2017, the personal exemption amount was $4,050, per exemption (you, your spouse, your dependents, etc…).

Passthrough Income Deduction:

Individuals will be allowed to deduct 20% of “qualified business income” from a partnership, S corporation, or sole proprietorship. Additionally, this deduction will apply to qualified real estate investment trust (REIT) dividends, qualified cooperative dividends, and qualified publicly traded partnership income. For the sake of keeping things brief in this article cannot go into details on this deduction, but if you are a small business owner you may be affected by this.

Child Tax Credit:

The act increased the child tax credit from $1,000 per child to $2,000 per qualifying child. They capped the refundable portion (the portion that you get whether or not you owe taxes) at $1,400. This credit also now begins to phase out at $400,000 for married filing joint tax payers, and $200,000 for other tax payers.

In my opinion, people that have children under the age of 17 should see this as a big win. Credits are always far better than deductions and the fact the credit doubled in addition to more people being eligible for it with the increased phase outs is going to make a big difference come tax time.

Alimony:

For any divorce or separation agreement executed or amended after December 31, 2018, alimony and separate maintenance payments are no longer deductible by the paying spouse. That is, if you’re paying alimony you (instead of your ex-spouse) will have to pay the taxes on it, and if you’re receiving alimony it will be tax free income to you.

The act essentially reverses the way alimony payments are treated for tax purposes. But if you think about it, there will be more taxes payed on the same amount of income earned. Generally, the one paying alimony is the higher earning spouse, and if that is income is now taxable at their higher marginal rates then more tax will be collected.

IRA Recharacterizations:

You can no longer undo a Roth conversion. A lot more upfront planning will need to be done when before you do a Roth conversion. You will no longer be able to figure out the appropriate amount to convert come tax time in April, rather you will need to figure it out before December 31st (a time when you might not have all the info you need to decide how much would be appropriate to convert).

Sale of a Principal Residence:

Although there was much talk about changing the rules behind the exclusion of capital gains on the sale of a principal residence, nothing was changed here. Phew!

Itemized Deductions:

Although most people won’t need to itemize their deductions anymore because of the increased standard deduction, there were various changes to itemized deductions. Here are a few of the bigger items:
The overall limitation on itemized deductions was removed through 2025.
Mortgage interest deduction was modified to reduce the limit on acquisition indebtedness from $1,000,000 to $750,000.
You can no longer deduct home equity loan interest.
State and local tax deductions are limited to $5,000 ($10,000 for married filing joint)
Miscellaneous itemized deductions subject to the 2% floor have been repealed.
The threshold for deduction medical expenses was reduced to 7.5% of adjusted gross income for 2017 and 2018.

By Justin Fundalinski, MBA | October 23, 2017

Are you receiving Social Security income, taking withdrawals from your IRA’s, or receiving a pension from a past employer?  Well, as a Colorado resident you could have some tax benefits on this income. Under Colorado tax code you may be able avoid including some (or all) of this income as taxable income on your Colorado tax return. Let’s dig into some of the details.

How do I qualify for this Pension and Annuity subtraction?

To qualify for the subtraction you have to meet a few requirements:

• You have to receive a qualifying pension or annuity income. (I’ll discuss more on this below.)
• You have to be at least 55 years or older by the end of the tax year.
  • There is an exception to this age criteria for pension or annuity income that is received as a beneficiary because of the death of the person who originally earned the pension/annuity income.

What types of income can be included in this subtraction?

The name of this subtraction is misleading because it is not limited to only pension and annuity income and unfortunately, not all pension and annuity income can be subtracted.  There are some general rules that Colorado has set forth for qualifying income. The income fall into the following categories:

• Federally taxable income that is, paid periodically, attributable to services performed through employment, and paid after retirement. (This type of income is resulting from an employee-employer relationship, service in the uniformed services of the US, or contributions to an employer based retirement plan that were deductible for federal tax services). This essentially sums up all employer based defined benefit plans (AKA employer pensions), military pensions, and annuitized employer based defined contribution plans (AKA annuitized employer based savings plans).

• Or, the income could be generated from:
  • Distributions from IRAs
  • Distributions from self-employed retirement accounts
  • Amounts received from fully matured privately purchased annuities
  • Social Security
  • Amounts paid out because of permanent disability, or death of the person entitled to receive the benefits

How much can be subtracted?

Each taxpayer is bound by a maximum allowable subtraction per year. In summary:

• If you are 65 or older you can subtract up to $24,000 of income
• If you are between 55 and 65 you can subtract up to $20,000
• If you are under 55 years old (utilizing the beneficiary exception) you can subtract up to $20,000

Considering the Centennial State has a flat income tax of 4.63% these subtractions often translate to substantial tax savings. For instance, if you are over 65 and maxing out the subtraction (you have more than $24,000 of qualifying pension/annuity income) your tax savings is just over $1,100. Additionally, this figure could double if filing jointly.

What should I watch out for?

There are a few items to be aware of when you are taking this subtraction:

• Each tax payer is eligible, so married individuals have their own maximum subtraction limit based on age. While this can be a major benefit, each tax payer must their own pension/annuity income to qualify. If one spouse’s pension benefit exceeds the maximum allowable subtraction, the excess cannot be subtracted under the other spouse’s allowable subtraction.
• Some additional calculations need to be done for spouses that both receive Social Security benefits due to how Social Security is taxed federally. Because the taxable amount of Social Security on the Federal tax return is combined for both spouses and the State requires these amounts to be separate, a little math needs to be done to find out each spouse’s share of the taxable Social Security benefits.
• Many of pension and annuity benefits do not qualify for the subtraction, so it is important you consult the Colorado tax code or a tax professional to ensure you don’t take the subtraction erroneously.

By Justin Fundalinski, MBA | July 20, 2017

With the real estate market showing strong growth year over year in Northern Colorado we have seen many clients purchasing rental properties to hopefully benefit from higher rents and rapid capital appreciation. This month’s article is not going to dig into the viability of such investing; rather it will overlay a perspective on how rental income, depreciation, and capital appreciation of rental properties affect one’s taxes now and later.

Rental Income and Expense Deductions

From the many tax returns I have reviewed or prepared there is a common theme. That is, because large depreciation expenses can be deducted against the income generated from rents, a hefty portion – if not all – of the income generated appears to be received tax free (and quite possibly creates a loss).  Of course, it is narrow minded to believe that you will never be taxed on this income and understanding the effects of how this effective tax deferral works may have you second guessing the alleged benefit of these so called “tax free rents.”  

How Depreciation Works

When you write off depreciation against your income you are essentially taking a write off at whatever your marginal tax rate is that year.  What you are also doing is lowering your basis in the property which will later be taxed at a special capital gains rate (not the normal 0%, 15%, or 20% rates) when you sell the property.  This special capital gains rate is called “unrecaptured section 1250 gains” and its rate is 25%.  So, what this essentially means is that any depreciation deduction that you write off on the building structure you are locking in a future tax rate of 25%.

 I would venture to say that an appropriate thought process on this tax deferral is similar to how we think about Traditional IRA or 401(k) contributions (sans the tax deferred growth factor).  If you are going to take a deduction from your income now to save on taxes the goal should be to realize the tax hit at a lower rate in the future than what it could be taxed at currently.  With the special capital gains rate on the depreciated portion of the structure at 25% that may be a difficult hurdle to overcome.  However, depending on other income that you are generating from employment or other sources this may be no hurdle at all.

Side Notes 

On a side note, I can feel that a savvy reader may be saying, “Well I don’t have to take the depreciation deduction and I can realize the income now at my current lower tax rate.”  Unfortunately that thinking is flawed.  The IRS assumes that the basis in a rental property is reduced at the maximum allowable depreciation amount; not at the rate at which you choose to depreciate.  

On a secondary side note, for any rental properties that were depreciated at an accelerated rate (that is purchased before 1986 and did not use straight line depreciation) there is a different set of “recapture rules.” It gets ugly to explain and does not apply to most people now that we are in 2017, but if you do have questions let me know.

On a tertiary side note, I will say that due to lending opportunities in the real estate market, I could make compelling arguments that using the rents to cover lending expenses solely for the sake of taking advantage of capital appreciation (and ignoring the income aspect) could be a viable strategy. However, that is not the topic of this article and warrants much more discussion around the pros and cons (so please to don’t take any aspect of this article as a recommendation for or against rental properties).

What about appreciation?

Capital appreciation (or any increase in value that you have above and beyond the original purchase price) is likely what most people are seeking right now when they purchase rental properties. The taxation on capital appreciation is just like any other capital gain.  You will be taxed at normal 0%, 15%, or 20% capital gains rates depending on what your total adjusted gross income is. In most cases that I have seen, some of the gain is taxed at 0%, the majority of the gain is taxed at the 15% rate, and if it is a very large gain or there is other significant income factoring into the equation some of the gain is taxed at 20%.  Keep in mind that this will be different for everybody and may significantly vary.

By Justin Fundalinski, MBA | April 25, 2017

Annuity income can play an important role in retirement planning because if used correctly, it can provide a steady stream of income for the rest of the annuitant’s life. However, while steady and secure income simplifies finances for annuitants (especially as they age), understanding how annuities are taxed becomes a bit more complex (not that you would ever have to figure it out on your own since the insurance companies will always report to you what is taxable, but good to know nonetheless).  In this month’s article I focus on how different annuities are taxed.

How is my annuity IRA going to be taxed?

This is the easy one! All qualified annuity payments (annuities that fall under the umbrella of an IRA, Roth IRA, or other tax deferred retirement account) will be taxed in the exact manner that they would be taxed in any other qualified account type. For example, Traditional IRA annuity income is taxed as ordinary income just as if you took a distribution from your IRA investment account.  Or, Roth IRA annuity income is tax free income just as if you took a distribution from any Roth account.

Is a non-qualified annuity taxed differently?

Non-qualified accounts (or often referred to as “taxable accounts”) are accounts that don’t fall under the qualified retirement account category discussed above. These are accounts like your bank account, or an individual/joint investment account. When an annuity holds onto non-qualified funds the taxation is substantially different than non-qualified funds in other types of accounts.

Here are some of the basics of taxation while the funds are inside of the annuity:

• The annuity grows tax-deferred. Unlike non-qualified accounts that often generate taxable income via interest, capital gains, or dividends, a non-qualified annuity does not subject the owner to taxes until the funds are removed from the account. When the gains are removed they are taxed as ordinary income.
• There is no step-up in cost basis at death. Unlike other non-qualified accounts that allow beneficiaries a step-up in basis and essentially avoid embedded capital gains on their inheritance, all the deferred earnings in a non-qualified annuity are taxable as ordinary income to the beneficiary. This rule applies to all non-spousal beneficiaries, but depending on the policy a surviving spouse may be able to retain the continued tax-deferred growth.

How is my income from non-qualified annuities taxed?

Income generated from a non-qualified annuity is taxed differently depending on how the income is being received. Income can be received essentially in two different ways; either, a stream of annuity payments, or as withdrawal from the annuity. This usually generates a bit of confusion so I will dive into a little.

Annuitized Payments

 When an annuity is actually “annuitized” you lock in a stream of income payments and you lose the ability to access the cash value of the account.  The keyword here is lock. Once annuitized you cannot withdraw any less or more than what the insurance company sends you and have absolutely no ability to close the account and take your principal back.

The taxation on these payments is fairly straight forward. First, the insurance company will determine something called the “exclusion ratio” which determines the percentage of each payment that will be excluded from income tax (essentially the percentage of premiums that you paid compared to the account value at annuitization).  Any income that is not excluded from tax will be taxed as ordinary income and will not receive any special tax treatment as dividends or capital gains may.  However, if the annuitant lives longer than the actuarial life expectancy  which means all premiums/basis will has been received back) then 100% of the payments become subject to ordinary income taxes. To recap this, initially part of each payment is taxed while part is not, and eventually (if you live long enough) all of it is taxed.

Withdrawals

 Withdrawals are a little sticky regarding taxation and some riders called “guaranteed withdrawal benefits” are often confused with annuitization.  So, let’s try to keep it as simple as possible.  All withdrawals from a non-qualified annuity force you to take your gains first, and then your premiums are returned to you.  So for example, if you put $50,000 into an annuity and it doubled in value to $100,000 then when you start taking withdrawals from it the first $50,000 withdrawn would be taxed as ordinary income while the last $50,000 would be tax free return of principal.

Guaranteed Withdrawal Benefit

Now, if you have a “guaranteed withdrawal benefit” the insurance company guarantees that you can begin withdrawing a certain percentage of the annuity for the rest of your life. Sounds like annuitization right? Wrong! The rules of “guaranteed withdrawal benefits” blend the rules of withdrawals and annuitization.

Let’s continue the example above.  $50,000 goes in, it grows to $100,000, and now a guaranteed withdrawal benefit of $10,000 per year for life begins. How does this get taxed? First, it gets taxed just like the simple withdrawal scenario did as explained earlier; earnings come out first, then a return of principal. But in this case, the account eventually reaches zero and you are no longer able to withdraw funds from this account. However, with guaranteed withdrawal benefits, once your account reaches zero your annuity technically becomes annuitized. Since all premiums have been received back, 100% of the payments become subject to ordinary income taxes until death. So if you took that all in and are a little confused think of it like this, first you’re taxed, then you’re not, then you are!

As always, this is a 30,000 foot view on the taxation of annuities. There is a lot more details and depth on this topic but these cliff notes should give you a good start on understanding it. If you have any questions please feel free to contact us at the office.

All guarantees are backed by the claims paying ability of the issuing insurer.