Taxes, Annuities & the SIPC

In addition to my computer, web and graphics work, I perform a number of financial services for individuals and small businesses. Among those services are tax preparation and investment counseling. It seems that late March and early April are my busiest seasons for both (hence my tardiness in getting April's Handmaidens up on time) and year after year the same questions arise. "How safe are brokerage houses where I may place my IRA?" "Are annuities a good tax deferral vehicle?" "What if I am audited by the IRS?" So, let's take a quick look at the answers:

Broker-Dealer Safety & the SIPC
Don't be afraid to place your IRA, SEP or other tax related retirement account with a broker, dealer or mutual fund. You'll usually earn a greater return than at the local bank, but only invest with those who are members of the SIPC.

The Securities Investors Protective Corp. (SIPC) is the nonprofit membership organization that protects customers of broker-dealers registered with the U.S. Securities and Exchange Commission, insuring a basic amount of each account from losses if the broker-dealer has financial problems. It does not protect you, of course, from losing money on your investments going bad.

The SIPC is funded by the member brokers and was created by the federal Securities Investor Protection Act. It is not a government agency or a regulatory body, however. Most brokerages are members, but you should check before opening an account.

Visit the SIPC web site where you can learn about the differences and similarities between the SIP and the FIDC, which insures your bank deposits.

IRS Audits
The days of random audits are thankfully long gone. Today, most audits involve little more than a letter asking you to explain or confirm something about your return. Your quick letter back usually settles things. Occasionally, you may be asked to appear at the local IRS office to document certain aspects of your return. If this happens, I suggest you hire a professional to accompany you to the meeting. The pro will know and represent your rights and can negotiate far more effectively with the auditing agent. Also, the agent is unlikely to try to intimidate you (yes, they still do that!) if there is a tax professional by your side.

Again, it's quite unlikely you will be audited at all, especially if you follow these simple guidelines:

• Unless yours is a very simple return, hire a tax professional. You'll usually save money in the long run and are less likely to face an audit.
• Be completely honest.
• Report all W-2 and 1099 income or attach a statement explaining why you couldn't. Failing to report all income is one of the top audit flags.
• Include correct Social Security numbers for all dependents and yourself.
• Attach all required supporting schedules and forms to your return.
• Report the name, address, and identification number of all child care providers.
• File your return or extension on time. If filing an extension, pay the taxes due when you file for it (no later than April 15).
• Attach a fully completed Form 8283 if you gave items worth more than $500 to charity.
• Avoid giant refunds or huge tax liabilities by adjusting your withholding or estimated tax payments.
• Don't round off to the nearest $50 or $100.
• If you prepare the return yourself, be sure it's neat and legible.
• Sign and date the return and send it to the appropriate IRS Service center.

Your tax preparer can advise you if your return contains audit flags. Even so, legitimate deductions shouldn't necessarily be shunned, just be prepared to prove them.

The IRS has three years to audit your return (from when it was filed or due, whichever is later), so keep all receipts and documentation for at least that long. If the IRS suspects fraud, however, they can audit with a vengeance long after the three year deadline.

The IRS has a comprehensive and very informative web site which even includes a statement of taxpayer's rights. The site is fashioned after a newspaper and is dubbed The Digital Daily. It's worth a good, long visit.

What About Annuities?
I am not a fan of annuities. Tax law changes over the past few years have provided us with far better deferral vehicles which allow us to provide for our retirement or build our estates without lining the pockets of salespeople or becoming trapped in poor investment situations. It's a sad but true fact that once a salesperson has pawned an annuity off on you, there's no graceful way out.

Annuities are tax-deferred investments in the guise of insurance that guarantee a regular future income. "Fixed annuities" pay market interest rates that are adjusted periodically. "Variable annuities" allow you to allocate your deposits among accounts similar to mutual funds with varying returns.

Some reasons these are poor investments are high fees, lack of liquidity, loss of personal control and capital gains that are taxed at higher rates when withdrawn. Annuities involve high expenses - management fees, insurance charges and annual contract fees. If you cash out, you'll pay surrender charges (sales loads) normally declining from 7% in year one to zero by year seven. The new crop of annuities claiming no surrender charges are no bargain either, they loads are just buried in higher fees. There will also be tax penalties if you cash out before age 59.5.

What if you're already trapped in an annuity and want out? First, accept the fact that there will be a price to pay. Better to take the hit now that continue in a terrible investment! Here are a few suggestions:

Take a tax loss. If you cash out at a loss, the loss is deductible against ordinary income. You can deduct the difference between your cost basis- all the premiums you paid less any tax-free returns, such as dividends - and your account value after any surrender charges.

Pay the taxes. Deferred annuities don't protect you from tax liability, they just postpone it. At some point you or your heirs are going to pay taxes on that money. Trouble is, annuities may be costing you more than the taxes they are deferring! You may be better off to just cash out and pay the taxes. Cut your losses and go on to better things.

As one financial writer put it, "There is no graceful way to divorce yourself from an annuity. The best solution: The next time the annuity salesperson comes calling, don't answer the door."

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