Investment choices have profound impacts on the tax requirements of retirees. In order to illustrate this, let’s consider two distinct groups of retirees — Group A and Group B.
Earnings from Different Investment Types
In Group A, each retiree receives an annual interest of $3 from a Certificate of Deposit (CD). Meanwhile, in Group B, each retiree garners $2 in interest every year from an annuity.
The annual income for each individual in both groups is $44,000. This income could originate from various streams—be it salaries, interest, or withdrawals from IRA, 401(k), or other tax-qualified accounts.
Unfortunately, once you start drawing Social Security benefits, an annual income of $44,000 leads the government to categorize you as a ‘wealthy retiree’.
The ‘Wealthy Retiree’ Tax Trap
So, what does it mean for Group A retirees who earn their interest through a bank CD? Each January, the bank sends them a 1099 form. This, colloquially known in retirement planning circles as an “I’m-telling-on-you form”, is the bank’s way of reporting to the IRS.
Let’s assume that Group A pays taxes at an overall rate of 28 percent, including both state and federal taxes. Thus, for that $3 of annual interest, they’re liable to pay a tax of 84 cents ($3 x 28% = $0.84).
But the tax obligation doesn’t stop there.
Because the $3 interest pushes their income beyond the government’s $44,000 limit, they’re also taxed on $3 of their Social Security benefit—specifically, on 85% of the $3 they received from Social Security. This equates to $2.55 (85% of $3), and 28% tax on $2.55 sums to 71 cents.
In effect, Group A’s $3 interest income invites a double tax—28 percent tax on the interest income and an additional 28 percent tax on $2.55 of their Social Security income.
The Tax Implication of Annuity Investments
The critical takeaway here is that the total tax paid due to that $3 of interest is an astounding $1.55, leaving them with a mere $1.45 as net income.
On the other hand, the $2 Group experiences a starkly different scenario. Their interest comes from an annuity, which offers the benefit of tax-deferred growth. As a result, their $2 interest isn’t reported on their tax returns since it was credited within the annuity and hence, doesn’t impact their Social Security income for the year. For the current tax year, it’s as if this income doesn’t exist.
The Essential Lesson in Tax-Efficient Investing
The crux of this comparison? It’s not the amount you earn but what you retain post-tax that truly matters.
Moreover, while everyone assumed they were in the 28 percent tax bracket, those in Group A paid $1.55 on $3 of interest, essentially placing them in a 52 percent marginal tax bracket — significantly higher than the top income earner in the US.
A Reality Check on Current Tax Landscapes
Today’s tax rates are historically low, and yet, our national debt has skyrocketed to a record high (over $31 Trillion). The most plausible solution for the government to amass sufficient revenue to repay this debt is by hiking taxes.
Are you prepared for potential tax increases?
Always remember: What you retain after tax is what truly counts.
Get in touch with us for tailored strategies on achieving this financial goal.
