(Pictured: Corey’s chicken scratch in meeting math vs. the actual tool that we utilize. One is better than the other.)
You’ve heard the famous line, paraphrasing, that says that the only things you can guarantee in life are death and taxes. Ben Franklin said it and he was quoting a play (and then eventually a book) that were written and performed some 70 years before he used the line. Franklin used the line in reference to the newly established Constitution of the United States in 1789 and has stuck with him ever since.
We had a client pass away about a month ago. She was going to turn 101 years old in November of this year. Eventually the first guarantee of Franklin’s quote will get us all, at least for this earthly shell.
This post isn’t about that first guarantee, though, it’s about the second. I like to write big picture thoughts and mindsets here in the blog but this particular post is going to get a little more technical. Sorry in advance. If you don’t like technical, well, Real Housewives of some county in the U.S. is probably on one of your TV channels. As an aside I’ve always wanted to pitch a Real Housewives of Loving County, Texas. There’s 57 people that live in Loving County. All 12 wives in the county would make the show so no one would feel bad…it’s also Loving County so they’d just give each other hugs and kindness and compliments…It would be great.
Anyway, we talked at length with the two sons about taxation of their inherited assets. Mom owned a non-qualified annuity as one of the pieces to her puzzle, and the boys rightfully knew that one of the options with a non-qualified annuity is to spend it over 5 years. Non-qualified annuities don’t get a step up in basis, meaning that any appreciation in that annuity at death will be taxed to the beneficiaries as they take money out. The boys were thinking that they would spread that taxation over time to make it less painful. We tend to do that a lot with taxation here in America. We think spreading it out will make it better just based on spreading it out. It’s like a peanut butter and jelly sandwich. It tastes better if it’s spread out instead of a giant blob. Sometimes that is certainly the case but you better do the math to figure it out because it’s not always the case. Have you ever tried a blobbed peanut butter and jelly sandwich. You might like it.
Let me stop here and remind you…we are not CPA’s. You’ve heard over and over throughout your life that financial advisors don’t give tax or legal advice. That is true, though at Baird we have been empowered with a tool called Holistiplan that allows us to at least point you in the right direction so that you can have a meaningful conversation with your CPA. It’s a wonderful tool and one that we utilize for clients a lot throughout the year while we’re doing planning.
Back to the boys. In this case, their knee jerk reaction of spreading taxation over time was in response to what most people think the most about which was income taxation. To make matters worse for a non-qualified annuity, the gain of these types of accounts are taxed as ordinary income not capital gains. There were two things the boys weren’t thinking about. The first is an unknown, even to a powerful tool like Holistiplan, and that is simply what happens to taxation after 2025. Buckle your seatbelt for a lot of bickering in Washington in regard to taxation in 2025 regardless of who wins the election. Assuming they took 1/5th every year starting in 2025, there are four distributions where we don’t have any idea what percentage of tax they’ll pay. The second thing that they weren’t thinking about was their Medicare premiums. Many people get surprised two years after they have a high-income year with a letter stating that they’ll pay more for Medicare for the coming year. This is called IRMMA and it stands for Income-Related Monthly Adjustment Amount. Your Medicare premium for B and D can go up depending on your income.
In this case, spreading taxation over time would make logical sense. I’ll have less income than I would if I took it all of it in one year. Less income the better for IRMMA and Medicare premium purposes. Sounds right, but in the older sons case it was wrong. His ‘normal’ income was so close to the IRMAA bracket that spreading the income over 5 years caused him to have additional Medicare premiums for all 5 years. That’s not a great scenario. Even spreading the annuity, since we’re at the end of the year, between 2024 and 2025, was worse (considering both income tax and medicare premiums) than taking all of the annuity money and paying tax on it today.
Ironically, as I was leaving the meeting I went back to my truck to find out I was parked beside a yellow jacket nest in the ground. I got stung twice on the hand. Nature’s reminder that knowing where the bee nests are can keep you from being stung. Luckily I’m not allergic to yellow jackets. Kate Lust, Bill Mancino, and I are also not allergic to pointing you in the right direction to avoid some of the tax code stings!