2 October 2013 0 Comments

The Cruelest Tax Of All

The Tax ManThis may be an exaggeration, but many people feel that having their Social Security retirement benefit taxed is the cruelest tax of all.  But that’s what has been happening for the past few years.  Even though you have made after-tax contributions, up to 85% of your Social Security retirement income could be subject to federal income tax.  Here’s the formula:

First, calculate the retiree’s combined income. Combined income is a total of:

Adjusted Gross Income (AGI)

+Non-taxable interest

+ ½ of retiree’s Social Security benefits

= Combined Income

Next, determine what portion of benefits will be subject to federal income tax:

  • There will be no tax if the combined income is less than $25,000 for an “individual” and less than $32,000 for couples filing a joint return.
  • 50% of Social Security benefits will be subject to tax for “individuals” with a combined income of between $25,000 and $34,000 and for couples filing a joint return with a combined income” of  between $32,000 and $44,000.
  • 85% of Social Security benefits will be subject to tax for “individuals” with a combined income of more than $34,000 and for couples filing a joint return with a combined income of more than $44,000.

Notice that non-taxable income normally associated with Municipal Bonds does not escape the formula for determining combined income.  If you’re wondering what your AGI is, it is on line 37 if you filed a Form 1040, on line 21 if you filed a Form 1040A or line 4 if you filed a Form 1040EZ.  And remember, 50% of your Social Security benefit goes into the calculation of combined income.

Are there any financial instruments offered by life insurance companies that escape the combined income formula?  Not annuities since withdrawals from Deferred Annuities are included in AGI up to basis and a portion of each payment from an Immediate Annuity is taxable and therefore part of AGI.  However, life insurance distributions during lifetime are subject to first-in-first-out tax treatment and thereafter policy loans can be used to avoid AGI.  At death there is no inclusion of benefits in the AGI.

With the performance of today’s Indexed Universal Life (IUL) policies being tied to the likes of the S&P 500, these policies can generate attractive income at retirement that totally escapes the combined income test and therefore does not negatively impact taxation of Social Security benefits.

If you’ve been following me for a while you might feel that I’ve covered IUL ad nauseam, but since this is so important and because I’ve got a new twist on the subject….

…next, it’s back to IUL and a way to avoid taxation of Social Security benefits.

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