Frequently Asked Questions About Tax-Aware Retirement Planning
1) I’ve been hearing about the changes in the tax law since 2018. What is the significance of this and what should I be doing?
The tax law changes did a few things. One, it reduced the tax bracket significantly from 2017 for tax filers of all levels. Two, it doubled the standard deduction for tax filers which added another level of lower taxation, mostly felt by middle-income earners.
The significance of this depends on what someone does with it over this 8 year period of time. To some it just means they get more money in their paycheck for the next 8 years. For others, it signals an opportunity to take current tax-deferred accounts and pay a ‘discounted’ rate on the future tax of that money and reposition it to a tax-free or tax-efficient vehicle.
And for even more, it means that they will change their retirement savings plans to pay taxes now on as much of their income as they can and invest it in tax-aware vehicles like a Roth IRA, Roth 401(k), or a Roth Alternative account.
2) What is a 72T?
72T is an Internal Revenue Service (IRS) rule that allows for penalty-free early withdrawal from an individual retirement account, 401k, TSP, 403(b), or 457 plan, when certain criteria are met.
3) My husband and I are in our 40’s and have 2 kids and a mortgage. He has a 401(k) plan at work and I have a 403(b) plan. We are encouraged by the company sponsoring the plan to invest as much as we can into the plans but I am concerned because all of that money is pre-tax. Is there something I am missing?
Even if your plans had a Roth 401(k) or Roth 403(b) option, only your contributions would be deposited into the Roth (tax-free account). Any employer match would still go into the pre-tax/tax-deferred account. You have to ask yourself if we are in a historically low tax environment and you have kids, mortgage interest, and property taxes that you can deduct-does it make sense to pay taxes today (pay taxes on the seed) or to wait and pay taxes later (on the harvest) when we don’t know what the tax rate will be.
4) I am over age 72 1/2 and am required to take out money each year from my IRA accounts. Should I be taking more out right now with this low tax environment?
This is a great question but one that requires careful analysis from someone with the tools to do that. In many cases, yes, you will want to. In some cases, you may want to take out quite a bit more due to the way that the middle tax brackets are currently set-up. But it comes down to each situation. But if you fall into that category you might be able to save a significant amount of taxes by paying them now, and repositioning them into a tax-free account and letting them grow tax-free for the future-either yours or your heirs!
5) I don’t need my RMD distributions but I want them to grow tax-free in the future. What are my options?
There are only 3 accounts in the US that will allow you to grow your money and take it out tax-free: Municipal Bonds, Roth IRA’s, and Life Insurance. Which account you choose depends upon your situation, future need (choose wisely so that you do not create a higher provisional income), and time-frame of need.
6) What is provisional income and will it affect me?
Provisional income is an IRS threshold above which social security income is taxable. The base, from §86 of the Internal Revenue Code (IRC), triggers the taxability of social security benefits, requiring its inclusion in gross income tax payment on excess amounts. Provisional income is calculated using the recipient’s gross income, tax-free interest, and 50% of their Social Security benefits.
7) My portfolio returns in my retirement accounts have beaten the stock market index returns for the past 10 and 15 years. Why should I be concerned about considering a Roth Conversion or Roth Alternative?
If you believe that taxes are not going to go up much in the future then staying on the current course may make sense to you. However, if you believe that taxes will go up considerably in the future then those tax increases could wipe out any significant market returns and even present a negative overall return for the account. Only time will tell but I would rather be in a tax-aware situation in the future and know that regardless of what is decided for future tax rates I get to keep 100% of what I withdraw from my accounts.
8) I have read about life insurance becoming a part of retirement planning but doesn’t that contradict ‘buy term and invest the rest’?
Life insurance (high cash value life insurance) is not becoming part of the retirement planning process, but rather it is no longer just for the wealthy or executives.
For some time, life insurance has been the retirement plan of executives-see the retirement plans for the CEO’s of Bank of America, AT&T, Boeing, Coca-Cola, Comcast, Exxon, GE, IBM, Lockheed Martin, The University of Michigan football head coach, The University of Alabama football head coach and many more.
Life insurance has become very sophisticated over the past 20 years and is far from what most people know about it. Buying term and investing the rest is a mentality that creates problems when the market corrects or when the person paying into the investment (401k, IRA, Roth, mutual fund, etc) becomes sick/disabled and cannot work.
But a high cash value life insurance policy can have a rider in which the life insurance company continues to make the monthly contributions when the individual cannot.
There are many other living benefits that make it a no brainer for executives who may have the knowledge that others have not had in the past but do now-or at least know where to get it.
High cash value life insurance is an investment class that increases diversification and does not have to be correlated to the stock market.
9) If I invest in high cash value life insurance, will my returns lag?
If you are looking at just the pure numbers on an illustration it may seem that way. However, in the early years of a high cash value life insurance policy you are giving up access to some of your cash value-so what is the trade-off? In return, you are getting other benefits.
It could be that you have a rider who pays the premium if you are unable to due to disability or critical illness. You also have access to a portion of the death benefit in the early years and throughout if you become sick due to a critical or chronic illness. Almost all other retirement plans lack these important benefits.
Lacking in these benefits is what causes people who get sick later in life to have to spend down their retirement before they even get there.
10) Morningstar reported that in order to safely be retired for 30+ years, their new guideline to retirement assets withdrawal rate guideline is 2.8%. How is it that I can take such a substantially higher distribution rate from a high cash value life insurance policy at retirement?
A high cash value life insurance policy (that is set up correctly with a proper carrier) offers higher distribution rates for several factors. The first is that if you are using a whole life policy with a strong dividend or a high rate Indexed Universal Life policy you are not taking on market risk and are avoiding what is known as “sequence of returns risk”.
Secondly, the distribution is considered by the US General Accounting Office to be a transfer of capital, not a realization of income, so the distribution is tax-free. These are just two of the reasons why withdrawal rates may be in the range of 5-6% from a whole life policy to 7-9% from an Indexed Universal Life policy (of course withdrawal rates will always depend on a variety of factors which is why you should have regular check-ups with your financial advisor).
11) The government is always changing laws, what’s stopping them from doing away with these strategies you do for your clients?
Tax law changes to this class of products have happened in history: specifically in 1982,1984, and 1988 with prior tax laws prevailing.
American tax benefits have a firm footing in the tax code and changes to that code have always been grandfathered in. It is also important to question, “what percentage of Americans will actually do something about getting tax-efficient”?
I have heard countless experts and best selling authors suggest that it may number in the range of 5% of Americans who are-and that’s not many. I further believe that the purpose of the current low-tax environment is to encourage those who wish to change their structure to become tax-efficient to do just that.
Therefore they will pay a higher ‘amount’ of taxes ‘through the sunset of these laws’ thereby generating additional current revenue for the IRS. Meanwhile the majority, 95% will do nothing and therefore pay significantly higher taxes in later years. Those who wait will have nothing to complain about as they too had ample time to prepare.
Safe Money Partners
If you have questions about tax-aware retirement, we’re glad your here. Schedule a consultation with us and we can go over any additional questions you may have about your current retirement plans and how to make sure you’re getting the best return on your investments.