There are three main taxes most of us can list without too much difficulty. Income tax should come to mind immediately, since we are in the middle of filing season. Sales tax is another we all see on a daily basis. Those owning property recently forwarded checks to the County and perhaps the City as well for property taxes on their home or other real estate owned. There are a number of other taxes we generally pay such as taxes on the use of phone lines, gifts, and even death or estate taxes.
Another tax most of us pay but few of us are aware we are paying it when we do is an excise tax. The purchase of automobile tires, luxury automobile purchase, heavy vehicle on public highways, gasoline, diesel fuel, natural gas, barges, fishing vessels, alcohol, air transportation, imports are all examples of excise taxes imposed, and the list could go on and on.
Retirees often find themselves paying more in taxes than they should. This may be caused by lack of knowledge of the income tax code but also by their conservative investment strategies. Those retirees who are fortunate to have significant investments often believe their tax strategies are too simple to hire professional assistance. While many tax preparers are just that, preparers; there are some preparers who will assist in developing a strategy to reduce your taxes. If you go to a historian, all they generally do is document the history as it occurred. Rarely do they venture into what could or should be.
The same is true with many tax preparers. They do a tremendous job of documenting the prior year but little in assisting the taxpayer with what should be done to reduce their tax burden.
One investment strategy most retirees participate in is Certificates of Deposits. The reason why is very easy to identify. In a retirees early years of investing, CDs were the most common form of improving your return, unlike today where mutual funds may be the younger generations choice. CDs are also very predictable and generally easy to understand. Investing in what you know and understand is not a bad rule to follow; but, if your choices are not working, then finding other ways is a must.
Because many retirees have income sources that are meeting their spending needs, the interest earned on CDs is often reinvested in the CD. This is one of those areas where you are paying a tax on your money even though you are not consuming it. Depending upon the amount of interest income, it could also be the cause of a portion of the Social Security income being subject to income taxes. Take a look at this example.
A couple is receiving $24,000 from Social Security, her school pension for $11,000, and his pension in the amount of $13,000. Without considering any additional income, their pension income alone is causing a small amount of their social security income to be subject to income taxes. If they are fortunate to have $200,000 in bank CDs earning five percent, they may feel good about the rate but not the tax impact. Adding $10,000 of interest income for the year increases their taxes by $1,956. While the example couple is in the 10 percent bracket, their tax on the additional interest income was higher than 10 percent because additional social security dollars also became taxable. Only the IRS can figure out how to get 19.56 percent in taxes when the rate is 10 percent.
A possible solution is to shift some or all of the CD investments into annuities. In many cases, the rate of return can be similar; but, since annuities are tax deferred, the earning will not be the reason as it was in my example of causing more of the Social Security income to be taxed. Before I go too far here, annuities come in all shapes and sizes. Many pay exorbitant commissions to the salesperson and impose very long surrender periods to protect the insurance company. As with all investment products, there are suitable annuities as well as the bad ones. Just take steps to make sure you are working with a qualified investment planner, one that knows taxes in addition to investments. Also, a portion of your investments should remain free from surrender or other penalties in order to be available should an emergency arise.
Shifting a portion from CDs to annuities is one way to help reduce your tax burden. With every case being unique, it would be advisable to seek professional help from an investment advisor with their CFP credential or someone else with both tax and investment knowledge. Even simple returns and investment strategies may result in paying too much in taxes.
HOW TO REACH THE WRITER
Would you like a response to a financial question? Send your question to Doug Horn, 115 W. Broadway, Maryville TN 37801. Be sure to mark your envelope Money Matters.
Doug Horn, CFP, is an area financial planner with more than 21 years financial experience and founder of Quality Financial Concepts, located in downtown Maryville on Broadway.
Doug Horn, CFP, Registered Investment Advisor in Tennessee and Texas and Registered Principal, Branch Office of and Securities offered through CUE Financial, Member NASD, SIPC.