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How Choosing the Wrong Investments Could Cost You $2,785 Extra in Taxes

Imagine two retirees: Mary and Peggy. Both earn the same income and both have the same deductible expenses. However, one pays about $2,785 less in taxes than the other. How? It’s all about how each structures her income. Let’s examine this further.

Wrong Investments for Taxes Means Where the Income Comes From

Both Mary and Peggy:

  • have social security benefits of $1,500 per month.
  • have a pension income of $12,000 per annum
  • have $500,000 in savings with the opportunity to earn 5%.
  • pay $6,000/year in property taxes and
  • incurred $3,000 in medical expenses during a typical year.

Mary decided to invest her $500,000 nest egg in a laddered corporate bond structure. Peggy invested her nest egg in a laddered annuity. Furthermore, she uses an immediate annuity for the first step of the ladder. And she breaks the remaining sum into different annuities maturing at future intervals.

Mary earns 3% blended on her $500,000 worth of corporate bonds yielding $15,000 of taxable income from her bonds on her tax return. Peggy also takes in $15,000 in cash flow but since this is an annuity and she can take advantage of the exclusion ratio, only roughly $2,100 of the $15,000 is taxable.*

Mary ends up paying $3,036 in taxes but Peggy only pays $215. Why?

Different Investments are Taxed in Different Ways

Mary’s taxes end up looking like this – her gross income includes:

  • her $12,000 in pension income
  • her $15,000 in interest income
  • and due to the rules, a portion of her social security -$6,200.

Her gross income is therefore $33,200. Peggy’s taxes look a little different.  Her gross income includes:

  • her $12,000 pension,
  • $2,100 from her annuity cash flow
  • and NONE of her social security income for a total of $14,100

Why? Because her “modified income” falls below the limits outlined by the tax law, her social security isn’t taxed (see IRS 1040 Instructions HERE for more info).

Furthermore on their schedule A’s, where itemized deductions are taken, Mary can deduct only $510 of her $3,000 in total medical expenses. The reason? She is limited to only amounts in excess of 7.5% of her adjusted gross income  (AGI – a tax term) x $33,200 ~ $2,490. Peggy’s threshold is lower due to her lower claimed AGI. She can deduct medical expenses in excess of 7.5% x $14,100 or $1,057.50. In other words ($3,000 – $1,057.50 =) $1,942.50 of $3,000 is deductible.**

A Detailed Breakdown of the Tax Effects of Choosing the Wrong Investments

To follow through, here’s how it looks (Note: for the curious, I put in another ‘retiree,’ “Joyce,” who invests her $500,000 in municipal bonds at 3% yield for more comparison):

Mary Peggy Joyce
Cash Flow $45,000 $45,000 $45,000
1040 gross Income $33,200 $14,100 $18,200
Exemption -$3,650 -$3,650 -$3,650
Property tax -$6,000 -$6,000 -$6,000
Medical Deduction -$510 -$1,943 -$1,635
Taxable Income $23,040 $2,508 $6,915
Federal Taxes** $3,036 $251 $693

**from IRS 1040 tax Tables http://www.irs.gov/pub/irs-pdf/i1040tt.pdf

In summary, re-engineering how you get your retirement income can lower your taxes  by changing your:

  1. gross income – by lowering realized income, you can keep your social security from getting added to your gross income and being taxed
  2. deductions – with lower adjusted gross income, higher medical deductions achieved
  3. taxable income – by keeping you in lower brackets for example

Bottom line: consider thinking through a more comprehensive planning methodology and see if there are smart strategies that can lower your tax bill. Additionally, with new tax law changes, for example the medical threshold being raised from 7.5% to 10% and the potential reversion to the older (and higher) tax rates, keeping realized income will become increasingly important if you want to keep more of the money you make.

Consider consulting with professional advice before making any commitments with your money – a mistake could cost you thousands…

For Further Study

For more information on whether current bond yields are a good buy, read my article:  Should Retirees Buy Bonds with Low Coupon Rates Now?

*Exclusion ratio is calculated by dividing the amount invested by the total value of payments. In this case, $15,000/year for 10 years = $150,000. To achieve this, $129,452.19 is deposited into a hypothetical 10 year annuity earning 3 % (for precise terms, get a quote from an insurance company. These figures are for illustrative purposes only). For more details on how an annuity ladder compares with investments that earn straight interest, call our office at 888.278.9433, email us, or contact us via our site form HERE.

This article was written to give you an idea of the possibilities that exist within the tax code for various income planning strategies and the resulting taxes. It is not meant as advice specifically to you, but only as a guide and hopefully an “eye-opener.” It is highly recommended that you consult with a professional with financial/tax decisions, especially decisions with medium to long term implications as outlined above.

Contact us for Help in Avoiding the Wrong Investments in Retirement

If you’d like local advice, feel free to call our office at 888.278.9433 or contact us via our contact form. We have a team of professionals that can help with your situation. Or schedule a phone appointment with Chris and the team using our online scheduling system:

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Please see my disclaimer page about tax advice on this site – thanks for reading!

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