Alan Haft

Taxable to Tax Free: Can It Be Done?

With the exception of a Roth IRA, where is it possible to withdraw earnings from a tax-deferred vehicle without ever paying tax?

August 16, 2010
by Alan Haft

Most people who understand a bit about taxes would understandably say there’s nowhere to do it. But as of this year, there is a way to do it and knowing the how and where can be a tremendous benefit.

Before explaining how and where it can be done, I need to take what might first appear to be a meaningless step back for a moment.

Pork: Not From Pigs Only

For purposes of this article, the kind of “pork” I’ll be referring to is not the kind found in a pig but rather, “special interest” pork, often found buried beneath bills coming out of Congress. 

For example, did you know the recent $787 billion stimulus package designed to bail us out of the credit crisis also contained an $886,000 provision to build a Frisbee course in Austin, Texas? 

Crazy, but true. 

For this article, pork is relevant is because of something that happened back in 2006. In that year, Congress passed a law that is commonly referred to as “The Pension Protection Act” (PPA). Primarily as a result of the Enron and Worldcom collapses, this Act was created to raise various requirements in order to protect those counting on corporate pensions. 

Although CPAs won’t find pork for Frisbee courses buried in the PPA, they will find buried treasures in the Act that have recently started to surface, such as doing away with the $100,000 income limit that currently allows anyone to convert their individual retirement account (IRA) into a Roth IRA. 

Not bad. 

But it doesn’t end there. 

Starting just recently, nested deep inside the belly of the PPA is a provision many don’t know of and that’s what this brief article is about.

Tax Deferment: Friend or Foe?

When marketing annuityproducts — historically — insurance companies have often highlighted the values of their tax-deferred treatment. 

Although there can certainly be value in tax-deferred investing, without a deduction, it often takes a lengthy period of time to recognize any of its benefits. In addition, as soon as these deferred earnings are withdrawn, the possible advantages of deferment often goes away because every earned dollar taken out will be taxed as ordinary income, which could negate every advantage the deferment had in the first place (especially since tax rates will likely go up over time and certainly not down).

Insurance company marketing has tried to argue against these objections but they’ve historically struggled to win the war and this brings us to the Pension Protection Act of 2006. 

The Power of Lobbying

When Corporate America wants to get something done, what do they do? They lobby, that’s what they do, and the insurance companies represent one of the strongest lobbying groups in the country. 

To try and help overcome the objections of tax deferment, the insurance companies lobbied to get some pork baked into the bill that could help them out when the PPA came about. And that was the desire to create a means of allowing at least some form of tax relief when taking money out of tax-deferred annuities.

Although they didn’t quite win the war, they did win a few important battles. 

Taxable to Tax-free

Let’s look at an example of life within a typical deferred annuity:

  • Suppose my fixed, variable and/or indexed annuity was funded with $25,000 after-tax dollars.
  • Years later, let’s suppose its value increased to $35,000, representing a deferred, yet-to-be-taxable gain of $10,000.
  • Assuming I am over age 59½, when I typically withdraw monies from this annuity:
    • According to the IRS, the deferred gains of $10,000 represent the first money out and are therefore taxed as ordinary income.
    • In addition, withdrawing these earnings could also cause additional taxes on my Social Security benefits as well.

With this little-known provision nested inside the PPA, as long as one takes the deferred earnings out for qualified long-term-care use, as of this year, these earnings can now be taken out completely tax-free. 

Over the years, many retirees I meet often “1035 transfer” their annuities from one company to another to receive better benefits along the way, but they generally try avoiding taking money out when reminded of the taxation they cause.

In the case in which a client has “1035 transferred” their annuity one or more times, the new provision within the PPA also allows the person holding the annuity to revert back to their original annuity’s cost basis and take the cumulative total of all deferred earnings out tax free as long as it’s used for qualified long-term care (LTC) as well.

The Need for LTC

Keep in mind statistics I’ve seen state that roughly 80 percent of retirees who have annuities will use at least some portion of them for LTC assistance, making this a potentially compelling provision to obviously share with those holding such accounts.

It’s critical to mention that because the provision is so new, tax-free withdrawals cannot be done from nearly all pre-existing annuities. Only a very short list of certain annuities currently have the proper language built into their contracts that supports this tax-free distribution.

Therefore, for those wanting to receive these tax free benefits, they will very likely have to consider whether or not transferring their current annuity to one of the few that provides this benefit is worth moving it to a new company or not.

In addition, also understand for the distributions to be tax free, certain criteria has to be met such as two of the six standard activities of daily living having to be validated by a qualified doctor. 

Furthermore, many people considering LTC often don’t wind up taking out a policy for various reasons such as the costs associated with them as well as the “use it or lose it” mindset. In annuities that support this new provision, whether or not your client uses the money for LTC is up to the account owner and should they choose not to use it for LTC, then they still retain the asset for whatever use they want or they can simply pass it onto heirs for inheritance. 

Lastly, for those clients in poor health who desire at least some form of LTC assistance, these annuities typically have limited underwriting that often requires answering only a few short questions without the need to go through complex medical underwriting commonly associated with traditional LTC policies. 

Bacon, spare ribs or Jimmy Dean?

Taxes, long-term care or annuities?

Sometimes you might find some buried treasures regardless of what kind of pork it is.

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Alan Haft is an investment advisor representative with an insurance license, author of three books including the national bestseller, You Can Never Be Too Rich, and makes frequent appearances in national print, television and radio media such as The Wall Street Journal, Money Magazine, CNBC, BusinessWeek and many others. The amounts represented in this article should all be considered hypothetical and for example only.

* For full disclosure, Haft is a part of a firm that utilizes all industries which typically includes us receiving percentage based fees for brokerage servicesas well ascommissions when implementing insurance based plans. Haft does not work for any particular financial company or industry nor should this column be construed as an endorsement or condemnation for any particular product. Readers should note that all views and vendor recommendations as expressed in this article are solely the author’s and do not necessarily reflect the views of the AICPA CPA Insider™ or the AICPA.

The AICPA’s Personal Financial Planning Section is the premier provider of information, tools, advocacy and guidance for CPAs who specialize in providing estate, tax, retirement, risk management and investment planning advice to individuals and closely held entities. The Personal Financial Planning Section is open to all Regular Members, Associate Members and Non-CPA Section Associate Members of the AICPA. If you are a CPA who wants to demonstrate your expertise in this subject matter, become a Personal Financial Specialist Credential holder. Visit www.aicpa.org/PFP to learn more..