Q Dear Rick:
Read your informative annuity article in a recent copy of the Observer – also have an annuity dilemma. I have been accumulating interest in my annuity for more than six years. I am 92 years of age and in a 25 percent tax bracket. Should I withdraw periodic amounts from my account that is now paying a little over two percent interest, or defer to my heir who will be mandated to withdraw everything within five years at his higher tax rate? Thank you for the privilege of your time.
E.
A Dear E.:
Before I answer your question, first let me explain the way distributions from annuities are taxed. An annuity such as the one you have, which is known as a fixed- income annuity, grows on a tax deferred basis. There are no tax consequences with an annuity until money is withdrawn. It is upon withdrawal that money is taxed. The first money that comes out of an annuity is considered income and subject to ordinary income tax. For example, let’s say you bought an annuity for $50,000 and today it’s worth $55,000. If you withdraw $5,000 the entire $5,000 is taxed to you. If you close out the entire annuity and receive the $55,000 once again, only $5,000 is taxed because the remaining $50,000 is your basis. Using the same numbers, if you withdrew $7,000, $5,000 would be taxed and the remaining $2,000 would be treated as a return of principal.
In reviewing the situation at hand, there are two issues to consider. The first is the financial issues and the second is the taxes. When you consider the financial issues, you are receiving a little over a two percent return, which in today’s world is a very good rate of return for a fixed income investment. After all, you can compare the return on annuities to certificates of deposit. With a certificate of deposit, you’re not even getting one percent return. Therefore, from a purely economic standpoint, it makes sense to leave the money in the annuity as is.
The second issue that needs to be explored is the tax issues. Currently, your bracket is lower than your son and thus, if you withdraw the money now there will be a lower tax cost. However, we never want to let the tax tail wag the dog. Ultimately, what we want to do is take taxes into consideration, focusing on what’s important and that is what ultimately ends up in your family’s pocket.
Even though your son eventually may have to pay more taxes, the fact that you are receiving an above average return means your money will offset that tax cost and thus, he would be left with more money in his pocket, even though he is paying a higher tax. Therefore, my recommendation is to leave the money in the annuity as is.
I’ve always said the goal should never be to lower your taxes. After all, do you think the people who won that $1.5 billion lottery would want to give up their winnings because of the amount of taxes they would have to pay? I don’t think so. I think they would focus on the hundreds of millions of dollars that ended up in their pocket. We should never forget that the way our tax system works is that the more money you make, the more you pay in taxes. Therefore, what I recommend to most people is that they be smart with taxes, but don’t let the tax tail wag the dog. After all, it’s easy to lower your taxes; just ask your employer to cut your salary; that would lower your taxes. Obviously, we wouldn’t do that and that is why you don’t want to let the tax tail wag the dog.
Good luck!
Rick is a fee-only financial advisor. His website is www.bloomassetmanagement.com. If you would like Rick to respond to your questions, please email Rick at rick@bloomassetmanagement.com