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Increased Tax Knowledge May Mean More Money In Your Pocket

 

Often, a single, well-thought-out tax strategy can put you in a position to keep significantly more of your investment earnings. That’s why it’s important to know the tax implications of your investment decisions.

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Answers to Seven Commonly Asked Questions:

1. I’ve been told I’m in the 24% federal tax bracket. Does that mean all my income is taxed at 24%?

 

There is no single rate at which all your income is taxed. Your tax bracket reflects the highest rate at which you'll pay federal income taxes (also referred to as your marginal income tax rate). However, some of your income will be taxed at lower rates. Here's how it works:

Hypothetical Example:
Single Taxpayer with $150,000 of Taxable Income

hypothetical_example


Planning Consideration for Question 1:

 

Be aware of the amount of your taxable income and federal tax bracket thresholds. Consider deferring some income to keep yourself out of the next highest tax bracket.

2. My tax professional uses the terms marginal income tax rate and effective income tax rate. What’s the difference?

 

The marginal income tax rate is simply the highest rate at which your last dollar earned will be taxed. On the other hand, the effective income tax rate is the actual amount of taxes you paid on all the income you earned. Using the results from the example above, please see the explanation below.

marginal_tax_rate_chart


Planning Consideration for Question 2:

 

Use your effective income tax rate when doing tax planning. Consider the effective income tax rate when doing tax planning exercises. The result will be closer to your actual taxes paid than using your tax bracket or marginal income tax rate.

3. If I'm a high-income taxpayer, do I need to pay the Net Investment Income Tax?

 

The Net Investment Income Tax (NIIT) became effective January 1, 2013, to help fund the Affordable Care Act. This additional 3.8% federal tax can impact taxpayers who exceed the modified adjusted gross income (MAGI)1 thresholds of $200,000 for single filers, and $250,000 for married couples filing jointly. The 3.8% NIIT applies to the lesser of net investment income or the excess of MAGI over the threshold amount. However, taxpayers may be able to avoid the NIIT by carefully managing their MAGI levels and net investment income levels.

question_3_picture


Planning Consideration for Question 3:

 

Consider strategies that lower MAGI1 and net investment income.

  • Tax-deferred annuities: If you do not need income now and would like for some of your assets to continue growing tax-deferred, a nonqualified annuity allows you to defer the growth. Because no income is being paid out, the deferred growth will not be subject to NIIT. However, if you start taking distributions, the growth may be subject to NIIT.
  • Charitable giving: Gifts made to charities may lower your overall MAGI.
  • Roth IRAs: Qualified distributions from Roth IRAs are not subject to income tax, so it will not increase your MAGI.
  • Municipal bonds: Income from these bonds is generally not included in MAGI.
  • Your workplace retirement plan: Distributions from most 401(k)s, 403(b)s, and other employer retirement plans are not considered net investment income, but will increase your MAGI.

 

4. Are all capital gains taxed at the same rate?

 

There are two types of capital gains:

  • Short-term: Capital gains on assets held for one year or less. These are taxed at ordinary income-tax rates.
  • Long-term: Capital gains on assets held for more than one year. These are taxed at capital-gains rates, which are more favorable than ordinary income-tax rates.

For 2018, long-term capital gains are applied to maximum taxable income levels for a Single filer as follows:

 
If Your Federal Taxable Income Is   Your Long-Term Capital Gains Tax Rate Is...
Up to $38,600   0%
 
$38,600 to $425,800   15%
 
Over $425,800   20%
 



Planning Consideration for Question 4:
 

  • Hold capital-gains-producing assets for one year or more.
    Taxes on your gains will be taxed as capital gains instead of ordinary income.
  • Consider the effect of mutual funds in your capital-gains planning.
    Holding mutual funds can be an effective way to diversify your holdings and benefit from professional fund management. However, the funds’ managers determine when assets are bought and sold. If they are bought and sold quickly, this may result in short-term gains that are taxable to you at ordinary income-tax rates.

5. Are all distributions from my deferred annuity taxed equally?

 

In the following hypothetical example, let’s compare the two. Let’s say Bob, age 62, decides to retire and use his deferred annuity for retirement income. The example shows what his first five years would look like if he chose withdrawals versus annuitization. 

Withdrawals

If taking withdrawals, all gains, which are taxable, will be withdrawn first. Basis,2 which is after-tax dollars invested in a deferred annuity, is not taxable and is withdrawn last.

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  • Annuity contract value when income begins: $200,000
  • Annuity contract basis: $187,000
  • Annuity contract gain: $13,000
  • For illustrative purposes, assumes no yearly gain or rate of return, and annual withdrawals are made at the end of each year
  • Withdrawals end when the contract value is depleted

For annuities, keep in mind that a withdrawal charge also may apply. Withdrawals will reduce the contract value and the value of the death benefits, and also may reduce the value of any optional benefits.

 

Year 1

Year 2

Year 3

Year 4

Year 5

Withdrawal Amount

$5,000

$5,000

$5,000

$5,000

$5,000

Taxable Portion on Gain

$5,000

$5,000

$3,000

$0

$0

Tax-Free Return of Basis

$0

$0

$2,000

$5,000

$5,000

Remaining Contract Value

$195,000

$190,000

$185,000

$180,000

$175,000

Remaining Contract Basis

$187,000

$187,000

$185,000

$180,000

$175,000



Annuitization


This series of guaranteed income payments is taxed on an exclusion-ratio basis, which means a portion of each payment is tax-exempt and represents a return of the initial investment rather than earnings or gains. Therefore, taxation is more evenly distributed throughout the years. 

  • Annuity payments may continue for your choice of:
            1. Your entire life (as illustrated in this hypothetical example).
            2. Your life plus the life of another person.
            3. A fixed period, such as 5 or 10 years.
  • Purchase payment amount: $200,000
  • Exclusion ratio: 76.8%.
 

Year 1

Year 2

Year 3

Year 4

Year 5

Income Payment Amount

$11,327

$11,327

$11,327

$11,327

$11,327

Taxable Portion

$2,628

$2,628

$2,628

$2,628

$2,628

Tax-Free Return of Basis

$8,699

$8,699

$8,699

$8,699

$8,699



Planning Consideration for Question 5:

  • For withdrawals, after all gains have been withdrawn, your subsequent withdrawals will not be taxable. This may be a good strategy if you prefer to pay more taxes now to receive non-taxable income later
  • Annuitization spreads out taxation. It may be a good strategy if you prefer taxation that’s more evenly distributed throughout your retirement years.

Note: Taxes are not the only consideration when choosing how to take income from an annuity. Consult your financial and tax advisors before deciding on the income option that’s right for your personal circumstances and needs.

6. If I take annuity distributions before age 59½, will I have to pay additional taxes?

 

Typically, the taxable portion of a distribution from a tax-deferred annuity that is taken prior to age 59½ will be subject to an additional 10% federal tax.

However, here are some exceptions to this rule:

 

Death of the Owner
After the death of a deferred annuity owner, distributions to beneficiaries are not subject to the additional 10% federal tax.

Disability
If an annuity owner becomes disabled, the additional 10% federal tax on distributions may not apply. Make sure the disability meets the IRS definition and regulations.

Substantially Equal Periodic Payments (SEPPs)
Distributions taken as SEPPs are free of the additional 10% federal tax. The payments must continue to age 59½ or for five years, whichever is longer.

1035 Exchange
The IRS allows you to fully exchange one deferred annuity contract for another without tax consequences, no matter your age. To qualify:

  • The owner(s) and annuitant(s) of both contracts must be the same.
  • The exchange must take place directly through the insurance companies. Cashing out one contract to purchase another may be a taxable event.

You also can perform a partial 1035 exchange, which means a portion of your annuity contract is exchanged for another contract. However, be aware that if you take distributions from either contract within 180 days of the exchange, the IRS may consider the exchange “disqualified” (that is, no longer tax-free).

7. What are the tax implications if my surviving spouse continues my annuity contract?

 

When a deferred annuity owner dies, his or her spouse may choose to continue the annuity contract as its new owner. In that case, the additional 10% federal tax may apply to distributions made before the surviving spouse reaches age 59½.


Do You Have More Tax Questions?

 

These questions represent only a sample of tax issues that may affect you. Talk to your financial and/or tax advisors about your circumstances and needs. Their knowledge and experience can be invaluable in helping you decide on tax strategies that are appropriate for helping you reach your long-term financial goals.

Tax Information:
 

The amounts shown on Forms 1099 and 5498 will be reported to the Internal Revenue Service (IRS). In general, these forms contain dividend, distribution, sale/exchange and account value information related to your annuity contract.

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Disclosures and Other Information:

 

1MAGI, for purposes of the NIIT, is generally defined as adjusted gross income (AGI) for regular income-tax purposes increased by the foreign earned-income exclusion and adjusted for certain deductions related to foreign earned income. For an individual taxpayer who does not exclude foreign earned income, the regular AGI will also be the MAGI.

2Basis: Also referred to as principal. Distributions of principal are not taxable.

This material is not intended to be used, nor can it be used by any taxpayer, for the purpose of avoiding U.S. federal, state, or local tax penalties. This material is written to support the promotion or marketing of the transaction(s) or matter(s) addressed by this material. Pacific Life, its affiliates, their 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. Only an advisor who is also a fiduciary is required to advise if the product purchase and any subsequent action taken with regard to the product are in their client’s best interest.

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.

Pacific Life refers to Pacific Life Insurance Company (Newport Beach, CA) 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.