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1For federal income-tax purposes, life insurance death benefits generally pay income tax-free to beneficiaries pursuant to IRC Section 101(a)(1). In certain situations, however, life insurance death benefits may be partially or wholly taxable. Situations include, but are not limited to: the transfer of a life insurance policy for valuable consideration unless the transfer qualifies for an exception under IRC Section 101(a)(2) (i.e., the transfer-for-value rule); arrangements that lack an insurable interest based on state law; and an employer-owned policy unless the policy qualifies for an exception under IRC Section 101(j).
Tax-Deferred Accounts
Typically used for enhancing long-term growth potential. There may be adverse tax consequences for early withdrawals. However, in return, there are no taxes on any investment earnings until clients need to make withdrawals or take distributions. As a result, while clients are invested, they keep more of the investment earnings, enabling assets to grow faster.
Example:
- A nonqualified deferred annuity, which is used to grow money for retirement. Early distributions (prior to age 59½) will generally be subject to both ordinary income tax and an additional 10% federal tax on the gains. Assets left within an annuity will continue to grow tax-deferred.
Tax-Exempt/Tax-Free Accounts
Can be used to help meet long-term expenses by generating tax-free income in retirement. Although clients pay taxes up front at today’s known rates, they may potentially eliminate any income tax on account earnings when withdrawn.
Example:
- A Roth IRA, which can create tax-free income for retirement. Since clients pay taxes up front when they contribute to a Roth IRA, these accounts work best when clients expect to be in a higher tax bracket during retirement years.
Generally, for earnings from a Roth IRA account to be distributed tax-free, the Roth IRA holder must have held the account for five years AND either attained age 59½, become disabled, passed away, or qualified for a first-time home-purchase exception.
When clients transition from their working to later years, their financial focus often shifts from growing assets to ensuring they are managing their investments in a way that maximizes retirement income. To achieve that goal, the purpose of thinking in terms of “asset location” should shift from “where should I locate assets?” to “from which locations (accounts) should I withdraw assets?” Consider reviewing the following scenarios with your clients:
1. Before Making Withdrawals, Clients Should Think about Their Net Income
While doing some financial planning with your financial professional, you and your spouse realize that after Social Security benefits and pension payments, you’ll need to withdraw a net $13,500 from savings to meet living expenses. Which account should you withdraw from? If the goal is to minimize income taxes and help make your retirement savings last, it may be a good idea to withdraw from the tax-free account. Why?
In this hypothetical example, if you withdraw from the tax-deferred account, it will deplete your savings by an additional $1,840 (12% tax rate). Withdrawing $15,340 would allow you to receive a net $13,500. In contrast, the tax-free account would only require $13,500 to be withdrawn without any additional federal tax.
2. Be Aware of Your Clients' Tax Bracket
Now, let’s add another hypothetical consideration to the previous example. You and your spouse’s annual taxable income from sources other than savings—specifically, long-term capital gains from the installment sale of a business, your pension, and the taxable portion of Social Security benefits—is $68,500.
- $16,000 (rather than $15,340) from your tax-deferred account, your total taxable income (long-term capital gains, Social Security benefits, pension, and withdrawals) would be $16,000 + $68,500 = $84,500. By looking at the current IRS tax tables, you realize this amount of taxable income moves you from a 12% tax bracket to a 22% bracket (which now results in long-term capital gains rates moving from a 0% to a 15% tax rate).
- However, if you withdraw $13,500 from your tax-free account, your total taxable income would still be $68,500, and this would keep your long-term capital gains at the 0% tax rate.
The takeaway from this example: Let clients know that moving to a higher income-tax bracket not only impacts taxation on ordinary income, but may also result in paying:
- More in capital gains tax.
- The 3.8% Net Investment Income Tax (NIT) for nonqualified assets.
- Tax on a higher percentage of Social Security benefits.
- The Alternative Minimum Tax.
- More retirement healthcare costs, such as increased premiums for Medicare Parts B and D.
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Effective Tax Rate EstimatorFederal income tax is calculated using a progressive tax structure, meaning that your effective tax rate is lower than your income tax bracket. As this calculator shows, even if taxable income shows you in a particular income tax bracket, overall, you benefit from being taxed at the lower brackets first.
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2022 Federal Tax Amounts and LimitsA quick-reference sheet of current federal tax amounts and limits. -
Lower Social Security Taxes and Medicare PremiumsHow tax-deferred investments may help lower taxes on Social Security benefits and Medicare premiums. -
The Power of Tax DeferralDiscover how powerful tax deferral can be in helping clients grow their assets, as demonstrated by three mathematical concepts. -
Uncover Opportunity: The Annual 1040 ReviewThe importance of annually reviewing a client's 1040 to uncover tax management and long-term planning opportunities.
The above is provided for informational purposes only and should not be construed as investment, tax, or legal advice. Information is based on current laws, which are subject to change at any time. Clients should consult with their accounting or tax professionals for guidance regarding their specific financial situations.
Under current law, a nonqualified annuity that is owned by an individual is generally entitled to tax deferral. IRAs and qualified plans - such as 401(k)s and 403(b)s - are already tax-deferred. Therefore, a deferred annuity should be used only to fund an IRA or qualified plan to benefit from the annuity's features other than tax deferral. These include lifetime income, death benefit options, and the ability to transfer among investment options without sales or withdrawal charges.
Want to Talk Further on this Topic?
The Retirement Strategies Group, subject-matter specialists with advanced degrees and designations such as CFA®, CFP®, ChFC®, CLU®, and JD, are ready to help.
Call
(800) 722-2333
In New York, (800) 748-6907
Email
RSG@PacificLife.com
Pacific Life, its distributors, and respective representatives do not provide tax, accounting, or legal advice. Any taxpayer should seek advice based on the taxpayer's particular circumstances from an independent tax advisor or attorney.
Pacific Life is a product provider. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products.
Pacific Life refers to Pacific Life Insurance Company and its affiliates, including Pacific Life & Annuity Company. Insurance products are issued by Pacific Life Insurance Company in all states except New York and in New York by Pacific Life & Annuity Company. Product availability and features may vary by state. Each insurance company is solely responsible for the financial obligations accruing under the products it issues.
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