Advanced Underwriting Consultants

Ask the Experts – October 3, 2014

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: Are there ways to minimize income taxes on Social Security retirement benefits?

Answer: Taxpayers often try to minimize the amount of their Social Security retirement benefits subject to taxation with a number of strategies. Particularly, taxpayers can delay filing for Social Security and use their available retirement accounts or assets in the meantime.

For example, let’s say Maude plans to retire at age 62 and needs $40,000 per year on which to live. Also assume that Maude’s PIA is $2,000 per month, or $24,000 per year.

If Maude files at age 62, she will receive $18,000 per year from Social Security ($24,000 reduced by 25%), and presumably make up the extra $22,000 per year from her tax-deferred retirement accounts. Therefore, the $22,000 is added to her adjusted gross income, and her provisional income is $31,000 ($22,000 AGI + ½ of $18,000 Social Security benefits). Since Maude’s provisional income exceeds $25,000, she includes $3,000 of her Social Security benefits in her gross income (i.e. half of the excess of $31,000 provisional income over $25,000 base amount).

Let’s say Maude files at age 70 instead, where she would earn delayed retirement credits at 8% of her PIA per year. In this case, her benefit would be $31,680 per year, requiring her to take out only $8,320 per year from her personal retirement accounts. Her provisional income in this situation is $24,160 ($8,320 AGI + ½ of $31,680 Social Security benefits); therefore, no portion of her Social Security retirement benefits would be taxable.

We’ve purposefully used elementary examples to show how delaying Social Security while using other means until filing for benefits can help avoid taxes on one’s Social Security benefits. We did not take into account the myriad variables that should be taken into account when deciding whether to file for benefits early or later.

Additionally, there are other ways to reduce provisional income. For example,

  • Keep assets inside qualified retirement plans, since distributions from tax-qualified plans are generally added to AGI.
  • Liquidate tax-qualified retirement plans before filing for Social Security benefits.
  • Invest in after-tax retirement plans, such as Roth IRAs or designated Roth qualified accounts.

As usual, the benefits of reducing the amount of Social Security benefits should be weighed against the costs of each of these strategies.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Ask the Experts – September 25, 2014

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: Are Social Security benefits subject to income taxes?

Answer: It depends on the taxpayer’s other income. Up to 85% of an individual’s Social Security benefits could be taxable. This doesn’t mean the taxpayer can lose up to 85% of her benefits; it simply means the taxable portion of her benefits may be added to gross income and taxed at her normal tax rates.

The first step in calculating what, if any, portion of a taxpayer’s Social Security retirement benefits are taxable, the taxpayer must calculate her provisional income for the year. Provisional income is generally the sum of:

  • (1)   The individual’s adjusted gross income (AGI);
  • (2)   Her tax-exempt interest (e.g., interest from municipal bonds); and
  • (3)   Half of her Social Security benefits.

For example, if an individual’s AGI is $22,000, and she earns $3,000 of interest from tax-exempt municipal bonds and $14,000 in Social Security benefits, her provisional income is $32,000 ($22,000 AGI + $3,000 tax-exempt interest + ½ of her $14,000 Social Security benefits).

The next step is to compare the individual’s provisional income to the base amount and adjusted base amount. The applicable base amount depends on filing status:

Filing Status Base Amount Adjusted Base Amount
Non-married individual $25,000 $34,000
Married filing jointly $32,000 $44,000
Married filing separately and lived apart during the year $25,000 $32,000
Married filing separately and lived together during the year $0 $0

The base amounts are not indexed for inflation.

If provisional income is less than or equal to the applicable base amount, none of the taxpayer’s Social Security retirement benefits are taxable. If the provisional income is larger than the base amount, a portion of the benefits may be taxable.

For a taxpayer whose provisional income exceeds the applicable base amount, but not the adjusted base amount, she must include in gross income the lesser of:

  • 50% of the excess provisional income over the base amount; or
  • 50% of the Social Security benefits received that year.

For example, suppose Maude, who files as an unmarried taxpayer, had $30,000 provisional income with $12,500 in Social Security retirement benefits. Her provisional income exceeded her base amount by $5,000 ($30,000 provisional income over the $25,000 base amount), which is less than her $12,500 Social Security benefits; therefore she will include half of the excess amount, $2,500, in her gross income for the year. This results in her paying taxes on 20% ($2,500 of her $12,500 yearly benefit) of the benefits she receives.

Additionally, if a taxpayer’s provisional income exceeds the applicable adjusted base amount, 85% of the excess is generally taxable. However, the highest total percentage of Social Security retirement benefits that may be taxable is 85%.

Here’s an example. Say that Maude received a Social Security retirement benefit of $24,000 last year. Also assume she had other income of $30,000 for the year, making her provisional income $42,000 ($30,000 AGI plus ½ of half her $24,000 retirement benefits).

For the first $9,000 of provisional income over the base amount, but less than the adjusted base amount, the tentative amount taxable is $4,500 (50% of $9,000).

For the extra $8,000 of provisional income over the base amount, the tentative amount taxable in this segment is $6,800 (85% of $8,000).

The sum of these two segments is $11,300, meaning she tentatively adds this amount to her gross income. We say these amounts are tentative because she can’t add more than 85% of her total Social Security benefits to gross income. Since 85% of her $24,000 Social Security benefits ($20,400) is more than the tentative amount of $11,300, $11,300 of Maude’s Social Security benefit is taxable.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.

Ask the Experts – June 13, 2014

Ask the Experts!

The professionals at Advanced Underwriting Consultants (AUC) answer the tax and technical questions posed by producers. Here’s the question of the day.

Question: My client (age 62, resident of Colorado) owns an IRA. Are IRA distributions subject to state income tax? If he wants to do a Roth conversion, will it be subject to state income tax?

Answer: It depends on the state. Colorado imposes a flat 4.63% state income tax is on its residents’ federal taxable income. Since both IRA distributions and Roth conversions are taxable on the federal level, they are both generally taxable on the Colorado state level.

However, Colorado allows a pension/annuity subtraction for taxpayers who are age 55 or older as of the last day of the tax year, or who are receiving a pension or annuity because of the death of the person who earned it. The pension/annuity subtraction allows a Colorado taxpayer to reduce his taxable income by the taxable amount he receives as a distribution from his IRA, up to $20,000 (or $24,000 if age 65 or older).

For example, suppose your client accurately reported $60,000 as taxable income on his federal income tax return. Generally, your client would owe $2,778 (4.63% of $60,000) in state income taxes. But suppose that $20,000 of his taxable income came from a distribution from his IRA. He can exclude this $20,000 distribution, resulting in a new taxable base of $40,000.

Additionally, the pension/annuity subtraction rule applies to Roth conversions. Therefore, as long as your client converts $20,000 or less to a Roth IRA in the taxable year, and doesn’t use the pension/annuity subtraction on another taxable distribution throughout the year, he may exclude the converted amount from the Colorado income tax.

Each state has different rules when it comes to income taxes, and there’s no universal rule as to the taxability of IRAs at the state level.

Sources: Col. Rev. Stat. § 39-22-104(f)(4); FYI Income 25: Pension/Annuity Subtraction, http://www.colorado.gov/cms/forms/dor-tax/Income25.pdf.

Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.