Retirement planning: Sources and taxability of retirement income

During retirement we wish to have a lifetime stream of income sufficient to support our lifestyle. Since taxability of income determines how much spendable income may be available, this is an important topic for consideration in planning for retirement income. In this article I will discuss income with regard to whether it is taxable or tax-free at time of receipt.

The financial planner's concern and objective is to help her client keep more of her money during both the asset accumulation and distribution phases, while paying her citizen's share of taxes due.

Currently taxable income includes wages and salaries, business and rental income, taxable interest and dividends, alimony, pension, annuity and IRA distributions received.

For 2006, the taxable income rate can be as high as 35 percent. While many more people with higher incomes are now finding themselves subject to AMT - alternative minimum tax - individuals with the highest incomes are not affected by the AMT because their maximum marginal tax rate (35 percent) exceeds the maximum AMT rate of 28 percent.

During the accumulation phase, several instruments offer the advantage of tax-deferred growth. These include qualified retirement plans, annuities and cash-value life insurance. When income is ultimately derived from these instruments, it will usually be as taxable income.

Retirement assets are commonly accumulated in qualified retirement plans (defined benefit and defined contribution). Advantages of these plans include: currently taxable income is reduced, plan assets grow tax-deferred, and a business can expense its payments for employees.

Withdrawals will be fully taxable as income and can trigger an early withdrawal penalty. Withdrawals by inheritors of retirement plan assets will also be wholly, or partly, taxable as income.

The newer Roth 401(k) and 403(b) plans allow after-tax contributions, which can grow tax-deferred, and will allow fully tax-free withdrawals. Benefits of these new Roth plans include lack of income phaseouts versus Roth IRAs, the ability to hedge against future tax increases, and the potential exemption from required minimum distributions beginning at age 70 1/2.

The Roth option could be superior to traditional retirement accounts if tax rates are higher when future retirees need to make withdrawals, particularly if withdrawals are delayed to age 73 or later.

However, if the participant's tax rate at retirement is lower and withdrawals begin before age 73, the traditional 401(k) may be advantageous.

Fixed and variable annuities also offer tax-deferred asset growth. Withdrawals from annuities are taxable as income except that the basis (principal invested) is not taxed. Early withdrawal penalties and sales charges may apply.

A life annuity guarantees an income stream that can never be outlived. Such a contract can generate a predictable stream of payments over a contractually agreed-upon number of years (or lifetime). The annuity payments systematically liquidate both principal and interest. The issuing insurance company backs the annuity payment guarantee.

A fixed annuity is purchased with a guaranteed rate of interest. In contrast, the investor assumes market risk when she invests in a variable annuity: its performance is dependent on the selected sub-accounts that vary in composition and risk.

Real estate investors have use of Section 1031 exchanges to defer the tax consequences of an equity gain in real property. These exchanges require careful planning and execution in order to comply with IRS 1031 regulations. Tenants-in-common (TIC) programs offer tax-deferred exchange of appreciated property into TIC interests in national and regional commercial properties to accredited investors (individual income of $200,000 per year; joint income of $300,000 per year; or minimum net worth of $1.0 million).

These triple-net leased properties currently pay approximately 6 percent (taxable as rental income) on the invested amount. This yield could increase over time with rent escalation clauses.

Retirees can derive income from additional instruments, including cash-value life insurance, charitable remainder trusts, and corporate and municipal bond portfolios (which generate, respectively, federally taxable and tax-free income). For the retiree, amount and sources of income can affect taxability of their Social Security (SS) benefit. If the retirees' "provisional income" plus one-half of the SS benefit exceeds a "base amount", then 50 percent to 85 percent of the benefit will constitute taxable income. Repositioning the income sources may reduce or eliminate taxability of the SS benefit.

This discussion is a brief overview of some of the wide array of available income generating vehicles. Your team of professional advisors (financial planner, attorney, tax advisor) can help you choose and structure a portfolio that is suitable for your particular circumstance.

Yvonne Naum, Ph.D., CFP, welcomes your questions and comments. You may contact her at 425-778-5649, toll-free at 800-859-7366 or via e-mail: ynaum@national

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