Why using the Fixed Annuity Mutual Fund Strategy Saves on Taxes

Possibly the only good thing about taxes is that you can do a little about them. They need not be accepted as a matter of course. While taxes are unavoidable in some instances, they can at least be reduced by employing nifty tax-reducing strategies. The strategy of tax shifting involves using a combination of mutual funds and short-term fixed annuities to reduce chargeable income from investments. It saves on taxes because it takes advantage of the prevailing tax bracket and the tax implications of mutual funds and fixed annuities.

• Background

Dividend income from mutual funds is subject to income tax, while only the earning portions of fixed annuity distributions are subject to income tax. Although income tax might be higher than capital gains tax, the tax shifting strategy lowers the chargeable income. This strategy is not for every taxpayer, and it generally works well for those who likely face a tax reduction in future or drop in income. The strategy is aimed at keeping the taxpayer in a lower tax bracket until the income level drops. Naturally, this works best for those whose investment income currently places them in higher tax brackets.

• How it works

Mutual funds generally provide decent returns on investment. For example, a feasible return for a mutual fund might be 10% – one dollar for every ten dollars invested. If the principal is high, then the returns might be large enough to place the taxpayer in a higher income tax bracket, since annual investment income is part of emolument income. Whether this obtains depends on the income derived from other sources as well.

Instead of investing in the mutual fund, the tax shifting strategy necessitates the use of the short-term fixed annuity in conjunction with the mutual fund. Instead of investing the principal in the mutual fund, the lump sum should be transferred or invested in a short-term fixed annuity (preferably the five-year version). Distributions from this would only be partially taxable, since part of the payment represents a return of the capital. For example, if the annuity payout is $2,000.00, only about $200.00 might represent the amount subject to income tax at prevailing rates and your tax bracket.

The distributions from the fixed annuity can be partially or fully invested in a mutual fund. This strategy reduces the taxable income from the total annual investment income to the earnings portion of the annuity distributions. Since the earning would accumulate rapidly after the first year, this strategy typically works for a two/three year period.

Using the fixed-annuity mutual fund strategy saves taxes because it reduces the taxable income by exploiting the tax advantages of a fixed annuity. While it is a short-term strategy that can benefit a limited number of taxpayers, it can save thousands of dollars for taxpayers who can benefit from it.