SANTA FE. The man sitting across from me at Zia Diner is Charles Padilla. He is a friend and neighbor, a man I have admired since we met over five years ago. Unlike me, a seasonal visitor from Texas, Charles can trace his roots back 200 years. His vision is multi-generational. He has a deep sense of our responsibilities to both our parents and children.   His horses, Jessica and Streak, often greet me from their corral when I make the morning trek to pick up my daily newspapers.

But while Charles is an accomplished horseman with deep Southwestern roots, we've gotten together for a completely different reason: Insurance.

A career Northwestern Mutual Life agent and Chartered Life Underwriter (CLU), his experience has given him an acute sense of money and time. After reading the book I coauthored with economist Laurence J. Kotlikoff--- "The Coming Generational Storm: What You Need To Know about America's Economic Future"--- Charles has been finding ways to use life annuities to side-step an issue mentioned in the book and earlier columns, the taxation of Social Security benefits. Now he wants to show me an example.

Here's the situation he outlined:

"A woman, age 70, has received $2,800 a month in alimony for 25 years. Her ex-husband recently died. The financial arrangement intended to replace alimony was a $150,000 life insurance policy," he said.

"His children inherited a $5 million estate. She has filed a claim against the estate for continued alimony payments. She will receive his Social Security benefit, improving hers from $750 to $1,400 monthly. And she receives rental income of $13,000 a year.

"It's clear that alimony represents a lifetime obligation that ends at the death of her (former) husband. It is equally clear that the mother has presented her alimony claim as an obligation of the estate. Her legal ground is very poor. But her moral ground is solid. The kids could fight her and win. But they can't win morally.

"The children would like to avoid the payment of $2,800 a month, settle the estate, and go on about their business."

I asked how the situation could be fixed.

"The tax savings in this situation can be very dramatic because you can avoid the taxation of Social Security benefits," Charles said.

He pointed out that her earlier situation--- $33,600 a year in taxable alimony and $13,000 a year in rental income--- had made every dime of her $9,000 a year of Social Security benefits taxable. As a consequence, her taxable income totaled $55,600.   Her deductions were the standard deduction ($4,850); the elderly deduction ($1,200); and her personal exemption ($3,100). They total $9,150. That left $46,450 of taxable income.

By adding $125,000 to her $150,000 life insurance proceeds, the children would enable her to buy a life annuity that would pay $22,000 a year. Only 20 percent of that amount is taxable income.

"Her new tax situation is $4,400 from the annuity, $13,000 from real estate, and virtually no taxable Social Security benefits. Her $9,150 in deductions leaves her with a taxable income a bit over $7,250," he said.

The result, when you do the full accounting, is that her cash income will have changed from $55,600 to $51,800, a decline of $3,800. But her federal income tax bill will have declined even further--- from $8,350 to only $1,000.

Net result: she has about $300 a month more to spend.

Basically, the inheriting kids will have ensured their mother's continued financial security with a life annuity, fulfilling their moral obligation and avoiding a lawsuit that would have been terrible for everyone.

This isn't an everyday situation. Lifetime alimony, in any amount, is fading faster than corporate pensions. And $5 million estates are rare.

The taxation of Social Security benefits, however, is increasingly common.

On the web:

Earlier columns on the taxation of Social Security Benefits:

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

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