Tax Shifting: The Fixed Annuity–Mutual Fund Strategy

by Alfred Kahl, PhD. -- Independent Financial Consultant

The Problem – High Taxes Now

This strategy is not for everyone, but some 50+ investors may benefit from it. It is useful if income tax rates are higher now than they are expected to be in the near future (5 years or less) as would be the case for those nearing retirement. The strategy may also be useful for those who receive Social Security benefits, as some of those benefits may be tax-free, depending on other income.

For example, suppose you have $100,000 invested in mutual funds now and get $10,000 of annual investment income (dividends and capital gains). The investment income might put you into a higher tax bracket. This strategy is more useful for Canadians since income tax rates there are higher than in the U.S. but the principle is the same. The marginal tax rate (the tax on the next dollar of income) on a typical Canadian investor whose taxable income exceeds $59,350 is 41%, but if income is less than that, the rate is only 36%, a difference of 5 percentage points. A U.S. investor would need over $278,450 to get into the 40% bracket and would be taxed at 36% below that. The problem is to reduce the taxable income to stay in the lower bracket for a few years, until retirement, for instance, when income would probably drop since retirees usually have lower incomes than when they were working.

The Solution - A Fixed Annuity plus Mutual Funds

Fixed annuities bought with after-tax dollars provide regular payments that are composed of a return of principal and interest. Only the interest portion is taxable income. In the above example the investor sold mutual funds for $100,000 and purchased a 5 year fixed annuity with the funds. The monthly annuity payment is $1,866, but only $189 is taxable because that is the interest portion (for more on this, see Chapter11 of IRS Publication 17, Your Federal Income Tax).

Since the investor did not need the income to live on, it is invested in a portfolio of 5 mutual funds each month. The mutual funds have been growing in value. Taxable income from investments has been reduced from the $10, 000 received last year to less than $3,000 this year ($189 x 12 = $2,268 from the annuity). As investments are made in the mutual funds they will, of course, generate more investment income from dividends and capital gains. It is possible to minimize dividend income by investing in growth funds, but these funds tend to generate more capital gains. However, capital gains distributions are usually made at the end of the year.

Thus, for at least 2 or 3 years the investor will be in the lower tax bracket. At the end of the 5 years the fixed annuity will stop and the investor will have a mutual fund portfolio probably worth $150,000 or more. Then, the investor could do it again, or perhaps use some money to live on and invest the rest. This would have to be coordinated with other sources of income as the investor might have IRA assets that would have to be liquidated after age 70½.

The Cost of the Strategy

The investor has to pay the insurance company for the cost of the immediate fixed annuity. There are also costs involved in selling the mutual funds to raise the original $100,000 including capital gains taxes. Of course, these costs could be avoided if you win the lottery or inherit some money from a long-lost relative. It is possible to invest in no-load mutual funds, so purchase costs are reduced, but there are still some annual expenses involved in mutual fund investments, but in this example they would have been incurred anyway so they are not relevant to the decision-making. In the example above, the client still came out ahead after tax, all things considered.

When Should Someone Consider this Strategy?

As mentioned above, this strategy is useful if the investor expects to be in a lower tax bracket soon and wants to shift taxable income to that later time period. It can be useful also if the level of income is important for other reasons such as the taxability of social security benefits or for qualifying for other benefit programs. It is most successful if the time horizon is 5 years or less because some time is needed for the tax benefits to outweigh the costs of implementing the strategy.