For almost 10 years, I’ve helped clients prepare for more confident retirements. While retirement preparation should be a top priority for families, many clients I see have not taken the proper steps toward a more stable future. Some have no income plan in place at all.
Most of the time I meet with my clients, they’re approaching their retirement years. I find they often have no idea about potential future health care costs, rising taxes, and other factors they may have to deal with in their retirement years.
The Magic of Compound Interest
Most people I speak with are well-versed in taxable investments. When we talk about taxing these investments, IRAs, 401(k)s, and 403(b)s are generally taxed just like ordinary income, while stocks, mutual funds, and real estate earnings generally pay capital gains taxes.
The majority of retirement earnings are the gains a person earns on their contributions throughout the years. Why do gains count for more than the contributions? The answer is compound interest. If you invested $2,000 a year and got an 8% gain at the end of the first year, your $2,000 investment would have grown to $2,160. At the end of 10 years, that $2,000 is now worth $31,290. At the end of 20 years, that investment is now $100,842.18. That’s the magic of compound interest.
Pre-Tax and Tax-Deferred
The real difference between pre-tax and tax-deferred retirement accounts is how the contributions and distributions are taxed. In the pre-tax account, you pay the taxes upfront, so the distributions come out tax-free. In a tax-deferred plan, there is no tax on the contribution, but taxes will be paid on distribution.
In the pre-tax plan, you won’t pay taxes in retirement because you already paid taxes on your contributions. On the tax-deferred plan, your gains will be taxed at your current income tax rate when they are withdrawn. Think about it this way: If you were a farmer, would you rather be taxed on the seed or the crop? We find that most people we talk to are only invested in tax-deferred plans.
Three Ways to Tax-Free Income
Here are three ways to acquire tax-free income. The first is through municipal bonds. The second is by making contributions to a Roth IRA. The third is using a life insurance policy to gain tax-free benefits while you’re still living.
Roth IRAs enable you to accumulate funds for a tax-free retirement. However, the government restricts how much you can contribute annually. The 2019 Roth contribution limit is $6,000, or $7,000 if you are 50 or older. The government also sets an income limit on who can participate. In 2019, the income limit for contributing to a Roth IRA is $122,000 for singles, which is increasing to $124,000 in 2020. For married filing jointly, it will increase by $3,000 from $193,000 in 2019 to $196,000 in 2020. For families earning more, the government will not even let you participate in a Roth IRA.
State and local governments issue municipal bonds. They use bonds to finance schools, roadways, and other public work projects. Interest earned on these bonds is exempt from federal, state, and local taxes. The problem is these bonds earn a lower rate of return than other investment options.
The third option for a tax-free income strategy is to use life insurance. A permanent life insurance policy will not only provide a death benefit to the insured’s family, but you can also use it as a savings vehicle. While qualified retirement plans have age restrictions to access funds, life insurance policies enable the policy owner to access their cash value with no age restrictions.
There are two basic types of life insurance – permanent and term. Term provides a death benefit for a finite amount of time. Premiums remain the same over the life of the policy and coverage ends at the term length, usually 10, 15, 20, or 30 years. These are temporary policies and do not accumulate cash value.
Permanent life insurance gives the insured coverage their entire life. These policies enable the insured to build up cash value, which he or she can usually access at any age.
A more complex type of life insurance is an indexed universal life policy, or IUL. An IUL provides the insured with flexible premium payments and can be an excellent option to help optimize retirement funds and reduce taxes on future distributions. Like a permanent policy, an IUL usually allows the insured to withdraw a portion of the funds from their policy at any time, as long as the policy is in force.
However, what’s unique about an IUL is when you take distributions, they’re considered loans, which makes the distributions have no taxable effect when taken. In addition, upon the death of the insured, the life insurance death benefit is paid to the beneficiaries tax-free – unlike qualified accounts, where the death benefit is taxed as ordinary income unless left to a spouse.
Just to review, here are some of the benefits of using some life insurance policies to help save for retirement that you may not benefit from with a qualified plan:
-Unlike qualified plans, there is no limit to how much you can contribute on an annual basis.
-You can access your funds before age 59 ½ without a penalty or tax.
-Your distributions from a life insurance policy will not be taxed when you take the distributions.
-Upon your death, the death benefit is paid to your beneficiaries tax-free.
I didn’t even mention policy riders that can allow you to add coverages like long-term care coverage. Long-term care can be costly today, and generally there is no premium protection, meaning the premiums can always go up. I’ve found many clients with long-term care policies don’t keep the policies because, as they age, they can no longer afford the premiums. Some life insurance policies offer riders that will cover long-term care expenses if you need them. I find this can be a more cost-effective way of helping to cover long-term care needs. If you or your spouse do not end up needing long-term care coverage, the premium will not be wasted, as the tax-free death benefit goes to the beneficiaries upon the insured’s death.
Most people I speak with haven’t considered using a life insurance policy to help accumulate savings and income in their retirement years. I work with my clients to use life insurance policies to protect against unexpected future costs, to leave a legacy to their family, cover their long-term care needs, and help reduce their taxes during their retirement years.