Learn practical planning techniques for how annuities can potentially increase your income and reduce your taxes at the same time, including lowering or even eliminating taxes on your Social Security and other sources of retirement income.

Benefit #1 – Tax-Deferred Growth

One of the primary advantages of deferred fixed annuities is the opportunity to accumulate a sum of money by allowing your premium and interest to grow tax-deferred. The interest that is earned on a privately owned annuity is not currently taxable by the federal or state government until you choose to make a withdrawal.

This is a notable difference between a deferred fixed annuity and other taxable financial vehicles. If you were to earn a 5% return on your money, that may sound good initially; but if you are in a taxable vehicle with a combined 28% tax bracket, the actual return is 3.60%. By the time you factor in inflation, you can see how difficult it is at times to get your money working for you the way you want.

In contrast, deferred fixed annuities can provide someone with a triple compounding interest environment! With annuities, you earn interest on your principal, interest on your interest, and interest on what you would normally pay in taxes. You will not pay income taxes on annuity interest until you withdraw it from your annuity. You control when you pay income taxes!

Some people notice the similarity between deferred annuities and IRA accounts in that both accounts accumulate on a tax-deferred basis. One advantage that non-IRA deferred annuities have over IRAs, is that there is no limit as to how much you can contribute.

While IRAs limit you to depositing a maximum of only $8,000 per year, with an annuity it doesn’t matter whether you want to put in $8,000, $80,000, or even $800,000 in a single calendar year, you are free to do so and can then immediately begin earning tax-deferred interest on that deposit.

Benefit #2 – Exclusion Ratio

When someone converts a deferred annuity to a pension-style income stream (also referred to as “annuitizing” an annuity), in many cases, a sizeable amount of the monthly income is paid back to the annuity owner tax-free.

The monthly cash flow received from all annuitized annuities represents a percentage of both taxable interest AND tax-free principal being paid out to the annuity owner simultaneously.

This is known as an annuity “exclusion ratio.”

Here is how the exclusion ratio is defined by the IRS tax code:

If payment under an annuity is payable at regular intervals over a period of more than a year from the starting date (P1371) (Reg 1.72-2B), all or part of it may be tax free, which is a return of principal. Excess is fully taxable. (Internal Revenue Code SEC 72-b-1, Reg 1.72-4-A)

When a person attempts to generate retirement income by investing their principal and living off the interest, 100% of that interest shows up on their tax return each year and is taxable at their normal income tax bracket.

Therefore, a $100,000 principal generating 5% interest through a bond or CD may create a BEFORE-tax income of $5,000, but after applying a 28% marginal tax rate, the spendable income left over is only $3,600 or $300 per month.

If the same $100,000 principal were to be annuitized through a fixed annuity, it could create as much as $625 per month of before-tax income but may have an exclusion ratio as high as 85-90%. This means that up to 90% (or $562 per month) of a person’s retirement income is completely tax free because the IRS views it as a return of your principal.

So again, starting with $100,000 of investment principal, if you could choose between $5,000 showing up on your tax return, resulting in $300 per month of spendable income, or only $750 showing up on your tax return resulting in $607 per month of spendable income – which would you choose?

There is also a secondary benefit to this approach. Not only do you save taxes on the income received from your $100,000 of principal in this example, but you are also hypothetically wiping $5,000 per year of taxable interest income off your tax return, thereby potentially lowering your taxes on your other sources of retirement income overall – which brings us to our next benefit.

Benefit #3 – Potential Positive Impact on Social Security Income

As we have now discussed, whether you invest money in a deferred fixed annuity that is simply accumulating interest on a tax-deferred basis, or you invest in an annuitized annuity that is paying out income in accordance with the “exclusion ratio” benefit mentioned above, you are effectively keeping a substantial amount of taxable interest income from showing up on your tax return each year.

As this relates to the Social Security income you are receiving, it is important to keep in mind that the IRS will impose additional taxes on your SS benefits if your total household income exceeds certain thresholds.

Here is how it works:

Currently, for a married couple filing jointly, the SS taxability threshold starts at $32,000 of combined household income, with an additional tax increase coming once total household incomes exceed $44,000.

To accurately determine the calculation, you must take 50% of your SS income, and then add in your pensions, rents collected, investment interest/income, etc. If that total number exceeds $32,000 – then 50% of your Social Security income now has to be reported as taxable income and will be taxed at your current bracket.

If you perform the same calculation and you end up with over $44,000 of household income, then up to 80% of your SS benefits may be taxed a second time. In a way, it is almost as though you’re being penalized for having any decent amount of income in retirement.

Now, suppose you add everything together as suggested above and are just over $44,000 per year of combined household income. However, also suppose that $13,000 of that total income is coming from the taxable interest that is being generated through your bond or CD investment portfolio.

By transferring some or all of that portfolio’s principal into a fixed annuity, you could actually increase the amount of spendable monthly income that is being generated from that principal, while at the same time reducing or even completely eliminating the taxes due on your Social Security income!

This is just one example of how the tax benefits of a fixed annuity can be used in a real-life planning scenario to favorably impact your taxes in retirement.

As with every investment strategy, it is recommended that you discuss your situation with a credible, licensed tax professional before making any investment decisions.