Q. I read with interest your article on annuities and Social Security taxation. It brought up questions that have been bothering me.   How does one determine whether a life annuity will protect Social Security income from taxation?   Are all life annuities only taxable at 20%?   When we retire in 6 months my wife and I (65 and 66) will each have a monthly income of $1650 Social Security, $1700 from my government retirement annuity and we will probably continue to earn $50,000 plus in part-time private practice for a few years.     The question is what to do with $700,000 in 401K accounts.

What will our tax situation be when we start taking distributions? Would it make sense to put some or all of the 401K money into a life annuity?   If we do this, should we wait until the rates are higher? (So many questions!).   I might add that our children are well off and my father is 95 and going strong and my paternal grand father died at 95 and his twin sometime after that! Any guidelines for our decisions in this area?

--D.K., by e-mail from Houston, TX


A.   The first thing everyone should know is that the taxation of Social Security is still a relatively uncommon event. This isn't because the tax doesn't begin at a modest income level. It is because so many retirees have less than modest incomes.

The next thing to understand is that no more than 85 percent of your total benefits can be taxed. For married couples the taxation of Social Security benefits begins when the combination of half of your Social Security benefits plus your other sources of income (including tax-free bond interest) exceeds $32,000 ($25,000 for singles).

A quick way to check how much income you can have before you start paying the tax on benefits is to subtract half of your Social Security benefits from the appropriate income threshold. In your case, that's $32,000. Since your combined Social Security income is expected to be $39,600 and half is $19,800, your other income can only be $12,200 before your benefits start to be included in taxable income.

Once your other income exceeds $12,200 each $1,000 of additional income engages the taxation of benefits.

Unfortunately, it gets still more complicated.

Between $32,000 and $44,000 of provisional income (half your Social Security benefits plus your other income) you'll be taxed on $500 of Social Security benefits for each $1,000 of additional income. Over $44,000 you'll have to pay taxes on $850 of Social Security benefits for every $1,000 of additional income--- up to the limit of 85 percent of all benefits.

You can visualize this in bands of income:

•  You can earn $12,200 without engaging the tax at all.

•  You can earn an additional $12,000 and only $6,000 of benefits will be taxed.

•  You'll need to earn an additional $32,500 before you'll reach the full taxation of 85 percent of your benefits, $33,660. In this band each $1,000 of income will cause $850 of benefits to be taxed. In effect you will be paying a very high marginal income tax rate on income from other sources.

•  Once your income from other sources exceeds $56,700 (the total of the three bands) you will have survived the gantlet. You'll return to normal tax rates.

It's important to know that each of us will start paying the tax at different income levels because there is a large variation in Social Security benefits. In your case, you'll go well beyond the taxation of Social Security benefits while still practicing.

Once you stop practicing and start living on Social Security, the $1,700 government retirement annuity, and 401(k) plan withdrawals, you'll need to withdraw at least $36,300 a year before you escape the taxation of Social Security benefits.

  You can hear our purported friends in Washington shouting, "Gotcha!"

Turning your 401(k) assets into a life annuity won't do anything to help you avoid the taxation of Social Security benefits because 100 percent of all withdrawals from 401(k) plans and IRA Rollovers is treated as conventional taxed income. That's one of the reasons economist Laurence J. Kotlikoff has suggested that many workers should pay taxes today and put some of their retirement assets in Roth IRAs.

If you have conventional assets you can turn them into a life annuity and reduce your taxable income. This happens because a life annuity basically returns your original principal to you in equal monthly payments over your expected lifetime. As a consequence, a portion of each payment is regarded as non-taxable return of principal. The older you are when you buy the life annuity, the greater the portion of the monthly income that is deemed return of principal. This happens because your life expectancy is shorter so more of the monthly income is return of principal.

Is there any escape?

Perhaps. Spend some time with your CPA and examine the possibility of converting some of your 401(k) plan assets into Roth IRA assets.

On the web:

Earlier columns on the taxation of Social Security Benefits:

Tuesday, August 17, 2004: Using a Life Annuity to Solve a Family Problem

Tuesday, February 11, 2003: Torpedo Tax Can Cause Sinking Feeling

Tuesday, February 18, 2003: Don't Get Caught In Early Retirement Tax Trap