Tax Planning Strategies for Annuity or IRA Withdrawals

Using Annuity Payments to Pay for Life Insurance

Here is an example of converting the tax liability built up over years through a deferred fixed annuity into a tax-free value for the heirs. This also works for IRA withdrawals.

Linda, age 70, purchased a fixed annuity for $50,000. She has held it for 6 years and the interest has caused the annuity to increase in value to $67,000. She mistakenly invested in the annuity thinking it was a good way to defer taxes for herself and provide an inheritance for her daughter. Unfortunately, she did not realize that for purposes of estate planning, a deferred annuity is not a good choice. Her daughter does not get a step up in basis under the IRS rules when she inherits the annuity and the daughter must pay income taxes at ordinary rates at the daughter's marginal rate when she inherits the annuity. If Mary were to die tomorrow, her daughter would have three options from inheriting the annuity.

• She could take a single lump sum distribution and pay taxes at her tax rate on an additional $17,000 in income.
• She could take a distribution over five years, but the same rules apply to her as apply to distributions from the annuity while Linda was alive, which means that the first $17,000 taken out are fully taxable.
• Within a year of receiving the annuity, the daughter could annuitize it into an income stream and pay taxes based on the rules applicable to an annuity income.

Linda at age 76 has a life expectancy of about 12 years. She could convert her annuity into a guaranteed stream of income $513 a month or $6,156 a year for as long as she lives and when she dies, her daughter can inherit this income stream. Now with this money Linda can shop around for a life insurance policy that will pay at least equivalent or perhaps more than the $67,000 that was in her annuity. Assuming she can find a life insurance policy for this amount, she has now converted a taxable event for her daughter into a tax-free inheritance.

IRA Donation

IRA owners age 70 1/2 and older can donate up to $100,000 of their IRAs to charity without having to report the withdrawal as income and deduct the donation as a charitable contribution. Deductions will not be limited by the Adjusted Gross Income cap on charitable contributions or the itemized deduction phaseout. Keeping IRA distributions out of adjustable gross income in the first place can also have other benefits. Amounts donated in this way count as all of part of the IRA owner's required minimum distribution.

IRA Lump Sum Distribution

A lump sum distribution is the distribution or payment, within a single tax year, of an employee's entire balance from all of the employer's qualified plans of one kind (pension, profit-sharing, or stock bonus plans). If the employee has more than one account in any category, all must be distributed as a lump sum distribution in a single tax year. Lump-sum distribution rules also apply to IRAs.

You may use the Special Averaging Method on your tax return to determine your tax on the lump sum distribution if you haven't previously used the Special Averaging Method for figuring tax after 1986 and you meet all the tests below:

1. you received everything due you from the plan within one tax year;

2. you participated in the plan for at least five years prior to the tax year of lump sum distribution;

3. the plan was a tax qualified plan under the tax law;

4. you were at least age 59 1/2 when the lump sum distribution was made, or, you were self employed and totally disabled if the lump sum distribution was made before age 59 1/2.

If you were born before 1936 and meet the above tax tests your lump sum distribution that you report on your tax return may qualify for special tax treatment that includes the 10 year averaging tax option, and the 20% capital gain tax treatment.

The 20% capital gain tax election can be made to compute the tax on your tax return on the taxable part of the lump sum distribution that applies to the portion received for participating in the plan before 1974. These choices allow taxpayers who were born before 1936 to have the pre-1974 taxable portion taxed on their tax return at a 20% tax rate, and the rest of the lump sum distribution, including the portion for all post-1973 participation, taxed on their tax return as ordinary income using the 10 year averaging tax option.

You should receive a Form 1099-R from your employer showing your taxable lump sum distribution and the amount eligible for capital gain tax treatment on your tax return. If you do not receive a Form 1099-R by February 1st you should contact the payer of your lump sum distribution.

You may also want to consider an IRA rollover instead of the 10 year averaging tax option. Mandatory tax withholding of 20% applies to a taxable lump sum distribution from an employer pension plan.

Long Term Care Medical Deduction Coupled with Annuity or IRA Withdrawals

If the household is incurring the high cost of long term care, this can be used as a deduction against taxable income. If the deduction is large enough, it could offset the taxable consequence of any withdrawals from a deferred annuity or an IRA.

Jim and Mary are a couple in their mid-80s. Jim is 87 and Mary is 82. Jim is in poor health and must go to assisted living. Their combined income is $2,500 a month which includes earnings from a CD. Jim has a fixed interest annuity that he purchased 20 years ago for $30,000 which is now worth $100,000. He has a $70,000 tax liability in the annuity. The couple also has a $70,000 CD. In addition, they own their own home free and clear and have a newer model automobile.

The assisted living costs $3,500 a month. The calendar year cost will be about $42,000 and this will produce a tax deduction after the equivalent percentage of adjusted gross income on their income tax return. Additional itemization gives them $33,202 of itemized deductions. But their income is $30,000. $25,000 of their income represents Social Security and that is not taxable because they are below the Social Security tax ceiling for a couple. With their exemptions of $2,000 and an adjustment for taxable income as well as the $31,202 itemized deduction, they have a negative taxable income.

The purpose for the annuity was to transfer money to their children. They were not planning on tapping into it. Jim realized that the annuity was a bad investment and that tapping into it would put his income above the Social Security limit and start creating taxes not only on the annuity income but also on their Social Security income. Unfortunately, the children would lose about 30% of the value of the annuity due to taxes, were they to inherit it. Jim withdraws $25,000 from the annuity and converts $25,000 of it into an income stream for his wife who is healthy, leaving $50,000 in the account which will come out next year using the same tax deduction strategy. The income pays out over her life span and if she dies within 10 years will continue to pay out for the remainder of the 10 years to a beneficiary. If Mary lives beyond 10 years, the annuity will pay out until she dies.

Next year, he will remove $50,000 from the remaining annuity account which also should be a nontaxable event if he is still in assisted living. Only $20,000 of this withdrawal represents taxable income and the balance represents his original investment which is not taxable. This $50,000 will also be converted into an insurance policy for the children. The remainder of the account represents his original contribution and is not taxable.

The annuity withdrawal is calculated to keep the Social Security that will be subject to taxes as a result of the annuity withdrawal, nontaxable due to the offsetting itemized deductions. The annuity withdrawal is a 100% taxable income event representing ordinary income. But, because of the long term health care deduction there is no tax due. The income annuity for the spouse represents the taxable and nontaxable portions of the $75,000 that was left in the annuity and does not create a great deal of taxable income because of the amount of income and because only about half of it is taxable.

Using this tax strategy, Jim will be able to get his entire $100,000 out of the annuity without taxes. The children are able to realize about the same amount that they would have inherited but without taxes and Mary is able to retain extra income for the rest of her life if Jim dies first.

All this tax planning may have produced a penalty for Medicaid which will be covered through additional planning.