Outside the Box: Can an annuity help me sidestep Social Security taxes?

Q: I read your answer about annuities and wondered about something. I am 72, single and am being pitched an annuity on the basis that I won’t pay taxes on my Social Security anymore. Is that true?

— Eleanor in Flint

A.: Eleanor, to some extent that can be true but generally I am not a fan of the strategy.

The portion of your Social Security payments that is taxable is determined by “combined income” which is your Adjusted Gross Income (AGI) + nontaxable income + half of Social Security payments. As a single taxpayer if your combined income exceeds $25,000 ($32,000 for joint filers), some of your Social Security will be taxable.

The higher your combined income, the more of your payments become taxable until 85% of the payments are taxable. At that point, even with more income, the remaining 15% of the payments are not taxed. The thresholds for taxability of Social Security are not adjusted for inflation.

Read: New Social Security bill retains — even enhances — benefits

By moving money from otherwise taxable accounts into a deferred annuity, the earnings on those funds are tax deferred and are not included in your AGI. Say you get $24,000 a year from Social Security and have $16,000 of other income including $3,000 of interest on your savings. Your combined income is $28,000 (the sum of half the $24,000 of Social Security and $16,000), making $1,500 of your Social Security taxable. With a standard deduction of $13,850, your tax bill is $368. (I will use the 2019 tax schedules for all examples in this piece.)

The pitch is to move the savings to an annuity so your AGI drops by $3,000. Now, your combined income is $25,000 so none of your Social Security is taxable. Your bill drops to $0 because the standard deduction exceeds the $13,000 of taxable income remaining.

Read: Never mind the Social Security increase — seniors are in trouble

What’s not to like? Strategically, the potential flaw is that if your income is low enough that avoiding tax on Social Security is possible, the effective tax rate applicable to you now is likely to be less than the rates that will apply later.

This happens because the earnings are only deferred not avoided. If you pull money from the annuity, by law, the earnings come out first and are taxed as part of your AGI. Back to our example, say you buy an annuity and a few years later you need $6,000. That $6,000 withdrawal is all earnings, puts the combined income at $31,000 and the tax bill would be $818.

Read: Don’t make this one Social Security blunder

Note that while $6,000 is twice $3,000, the tax bill more than doubles what I described above when the $3,000 had not been deferred in the annuity and some Social Security was taxable. This happens because more Social Security becomes taxable with the additional income.

The longer you wait to make a withdrawal, the larger the deferral and the bigger the potential tax bill. For instance, pull $24,000 of earnings and the tax bill, under the 2019 scale, would be $4,752 because nearly 72% of the Social Security payments are taxable and you crossed into the next marginal tax bracket where a higher rate applied.

Read: People who saved for retirement are being punished by Social Security taxes

Now, if you never remove money from the annuity, your heirs will pay tax on the earnings at their tax rates. If you leave these funds to gainfully employed people, it is possible the taxes due then could be much more than the taxes you saved during your lifetime. So, if preservation is important to you, deferring income like this works against that goal, too.

If you have a question for Dan, please email him with ‘MarketWatch Q&A’ on the subject line.

Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.

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