By Boyce F. Lowery, CLU, ChFC
When it comes to accumulating assets for retirement, you have more options than you may realize. While you’re probably aware of the plethora of investment options available to you, I’m thinking of a financial option you may not have considered. Of course, various accumulation vehicles are taxed differently and that fact should make you think about which options you choose. Depending on which of the various options you choose, your retirement income could be from sources that are taxable, tax deferred or tax free. Hint: I like tax free!
Using taxable accounts to accumulate assets for retirement income cost you the most. You get taxed on your money before you deposit or invest it and then you get taxed on the growth each year whether you take out the interest/growth or not. You don’t get any tax breaks with taxable accounts.
A bank savings account, money market account or certificate of deposit would be examples of accounts that are taxable each year. The obvious downside to using taxable bank accounts and other types of accounts that are similar is the lack of tax savings. Conversely, the benefit of taxable accounts is that there are no restrictions on the unfettered use of the money unless you have elected to deposit the money for a period of time under penalty for early withdrawal.
Tax-deferred accounts are not taxed during the accumulation phase and some types of accounts actually allow one to start accumulating with pre-tax funds. However, when funds are withdrawn from tax deferred accounts, taxes will follow. In many cases, withdrawals of funds prior to age 59 ½ will also trigger a 10% tax penalty. Further, if you are unfortunate enough that tax rates turn out to be higher than was the case when funds were being deposited into a tax deferred account, then tax deferral will actually penalize you. Conversely, if tax rates are lower at the time of withdrawal, you will benefit by having deferred the taxes. A few examples of accumulation vehicles where you can defer paying taxes until retirement are traditional IRAs, 401(k)s, 403(b)s, and certain 457 plans.
The disadvantage of tax-deferred income is that you do, eventually, have to declare income from the distributions you take. Unfortunately, having taxable retirement income can affect how much of your Social Security benefits are taxable and your eligibility for certain programs. This taxable income will also influence your costs for Medicare benefits once you reach age 65. Some individuals over age 65 are already paying over three times more than others for Part B of Medicare. If your taxable income is low enough, the current Medicare Part B premium is only $134 monthly. However, if you did a really good job of preparing for retirement by setting up accounts to pay you taxable income and/or have other income during retirement, you may have to pay as much as $429 per month at current costs. Taxable income from retirement accounts can end up hurting you in ways you presently may not have contemplated.
All other things being equal, the best retirement income available to you is tax-free. When you receive the money in retirement, you don’t have to pay any taxes on these tax free funds whatsoever. Often, you have to pay taxes on the front-end, though. Roth retirement plans and “maximum funded” life insurance plans are both tax-free accumulation vehicles.
With a Roth plan, whether it is an IRA or 401(k) with Roth contributions, you invest after-tax dollars. When you withdraw the money in retirement, you don’t have to pay any taxes, even on the growth. The problem with Roth 401(k)s is that they are not widely available. Only workers whose employer offers one can use one.
Roth IRAs are open to any worker, as long as they don’t exceed a specific income threshold. One nice thing about Roth IRAs is that they do not have required minimum distributions. However, they also have fairly low annual contribution limits; $5,500 for those under age 50 and $6,500 for those 50 years old or older in 2018. Also, for growth to be tax-free, it cannot be withdrawn before you turn 59 ½ or before it has been in the account for 5 years.
“Maximum funded” life insurance is different in that it is not an investment account like the others mentioned, but rather a life insurance contract. With “maximum funded” life insurance, the death benefit is minimized based on the amount to be paid in annual premiums in order to reduce the applicable fees. When structured properly, it can do all of that while still retaining the strong tax advantage of providing tax-free income.
Utilizing such a policy for retirement planning is easy because there is no limit to the amount that can be set up as the premium payment structure and there are no income limits for qualification. For those looking to accumulate money over a reasonable time frame before taking income, a life policy can be amazingly effective and provide tax-free cash flow for a very long time.
Further, in some states including Utah, life insurance policy cash values are off limits to creditors, even in bankruptcy proceedings. A caveat is that any premiums not having been in a policy for at least 12 months are not protected (in Utah).
Which One Is Best?
The great news is that these accumulation vehicles are not mutually exclusive. You don’t have to pick just one. There isn’t one best option, but the best financial plans utilize a combination of multiple vehicles for diversification of retirement income.
Having different types of income available to you in retirement means you have the power to manage your tax liability. For proper diversification in retirement, your traditional retirement account will not be enough. You will need a tax-free vehicle as well.
How diverse is your future retirement income stream? Would you like to know if you could be doing better? If you would like an expert opinion on your retirement plan, call us at 888-827-0146. We can schedule a complimentary, confidential consultation to review your current retirement plan and determine if any changes would be to your clear benefit.
Boyce Lowery is a 40-year veteran and established expert in the insurance industry. As the founder and Managing Member of Suncrest Advisors, he aims to provide financial security and peace of mind to business owners, executives and professionals, and high net worth individuals across the United States. Along with more than four decades of experience, he is a Chartered Life Underwriter® (the premier designation for insurance professionals signifying specialized knowledge in life insurance and estate planning) and a Chartered Financial Consultant® (known as the advanced financial planning designation). To learn more, visit http://suncrestadvisors.com/ or connect with Boyce on LinkedIn.