Trimming Taxes on Your Social Security Benefits with Annuities

For most retirees living on a fixed income, every penny counts. Unfortunately for them, every penny counts to the Internal Revenue Service, too. Retirees whose income — including half of Social Security benefits plus unearned income such as tax-exempt interest from municipal bonds — exceeds the IRS threshold can find up to 85 percent of their Social Security benefits are subject to tax. With the threshold for 2002 set at $44,000 for joint filers and $34,000 for single filers, retirees can be facing a tax bite of thousands of dollars on their Social Security benefits.

There are a few fairly simple methods seniors can take to reduce taxes on Social Security, mostly by taking steps to get their income under the threshold.

Often, retirees have money in certificates of deposit earning interest. They don't immediately need the income, and they just roll over the CDs when they mature. To reduce income, and the accompanying taxes, retirees can take the money out of CDs and put it into an annuity. Putting the money in a single-premium or variable annuity allows you to defer the income until you need it.

One advantage to an annuity is that you don't have to tap into the money until you actually want it. With an IRA, on the other hand, the money grows tax-deferred, but you must start making withdrawals by the time you reach age 70 1/2. Those required IRA withdrawals would affect your tax picture.

With a single-payment annuity, where the rate of return is guaranteed, a retiree has the comfort of knowing what his money is going to earn. On the down side, if you lock in rates now and the market turns around, your return might be much lower than you could get through stocks. And once the money is in the annuity, your investment isn't liquid.

A variable annuity, where you select the investment options, does give you the opportunity to earn more if the market goes up — but your earnings can also drop with the market. Liquidity might be an issue, too, depending on what you've purchased.

An annuity can be as simple or as complicated as you want. Buyers can sometimes choose options such as a nursing home-care clause, guaranteed return or guaranteed death benefit. Be sure you understand an annuity contract before signing it.

Investing in real estate investment trusts where the dividend is partially deferred, due to depreciation pass through, is another way to invest money that you don't need income from immediately and therefore trim taxes.

If you want to lower your taxes but still need the income, consider tapping into the cash value on your variable universal life policy. If you take out your contributions first, you owe no tax on that money.

Another tax-cutting strategy retirees often overlook is the good old home mortgage deduction. Many people want to own their home free and clear during their retirement years, but that might not be the best option. Even if the amount of mortgage interest you can deduct isn't terribly large, that amount might help you meet the IRS threshold for itemizing your deductions rather than taking the standard deduction.

Retirees who have a good handle on where the money comes from and where it goes might be able to employ some of these strategies on their own; others might need to get help from a financial adviser.

If you are within a year of retirement, do a little planning to figure out your income needs for retirement and see how that plays out in the tax picture. Then you can choose the benefits that work best and move assets to suit your situation.

If you don't do some tax planning before you retire, those taxes on Social Security benefits can come with another unpleasant surprise: Unless you submit a form W-4V, Voluntary Withholding Request, to the Social Security Administration, income taxes will not be withheld from your Social Security checks. You'll be responsible for making quarterly estimated tax payments and you could face a penalty for failure to make those payments or underestimating how much you should pay each quarter. So a little planning can help you avoid major tax headaches.