Are tax rates set to increase? What happens to retirement income if taxes go up?
Currently, income tax and capital gains tax rates are at historically low levels.
The US government debt has reached $31+ trillion, with $170+ trillion in unfunded liabilities. State and individual debt burdens are similarly concerning.
How will government entities finance their mounting debts and deficits?
One possible solution is for the US government to “print money” to cover its spending, as it has done in the past. However, the 50 states do not have the authority to print money, limiting their financing options.
If we assume that the federal government will not change its current fiscal habits, it is reasonable to expect that federal and state income tax rates will significantly increase in the future. (Stephanie Kelton’s book “Deficit Myth” presents an alternative, more sensible monetary approach.)
Therefore, it makes financial sense to adopt a strategy that reduces the future taxation of retirement income.
Many individuals have a significant portion of their retirement savings in taxable investment accounts and pre-tax tax-deferred retirement plans (e.g., IRA, 401(k), 403(b) plans). While retirees may have lower incomes, higher overall income-tax rates could eat into their retirement earnings. Additionally, investment accounts and tax-deferred retirement plans heavily invested in the stock market are exposed to market volatility and risks, as exemplified by the events of 2022.
Possible Solutions
To achieve tax-free income, consider the following strategies: (1) Move some assets from taxable investment accounts, CDs, and money market accounts into indexed universal life insurance (IUL). (2) Take advantage of the current low tax rates by paying taxes on current income and investing the post-tax amounts in Roth accounts or, ideally, in IUL. (3) If you are at least 10 years away from retirement, gradually convert pre-tax retirement plans (e.g., IRA funds) into post-tax Roth plans. (4) Transition assets into one or more asset-based tax-advantaged long-term care (LTC) policies that offer tax-free LTC benefits. (5) Invest pre-tax earnings in a 401(h) medical savings account, where contributions, growth, and distributions are tax-free.
Note: If your employer matches contributions to a pre-tax 401(k), 403(b), or other tax-qualified retirement savings plan, it is advisable to contribute up to the maximum matching amount.
In a Roth conversion, funds from an IRA, 401(k), or similar tax-deferred plan are transferred to a Roth plan, and taxes are paid on the converted amount. If converting a large sum, spreading the conversion over several years can help avoid being pushed into higher tax brackets due to the immediate tax obligation.
Simply reducing taxable income in retirement can have its advantages. Lowering taxable income decreases the so-called “provisional income,” which affects the taxation of Social Security benefits. Taxable income also influences “modified adjusted gross income” (MAGI), which determines Medicare premiums. By reducing taxable income, you not only save taxes on that income, but also reduce the taxation of Social Security benefits and lower Medicare premiums.
Generally, Roth plan withdrawals before age 59½ are subject to a 10% penalty, similar to pre-tax plans. Roth IRAs do not have required minimum distributions (RMDs), but Roth 401(k) plans require RMDs starting at age 72, just like standard pre-tax plans. Moreover, when the owner of a Roth IRA or Roth 401(k) plan passes away, the beneficiary is subject to RMDs.
Is there a better alternative to a Roth account for generating tax-free income during retirement and for legacy planning? The answer is yes. A well-designed indexed universal life insurance (IUL) policy can offer the benefits of tax-free growth and tax-free income, similar to a Roth plan, while providing additional advantages that Roth plans lack.
For instance, the cash value of an IUL policy does not decline during bear markets. While traditional retirement plans may allow investing in risk-free annuity policies, assets in both pre-tax standard plans and post-tax Roth plans are usually exposed to market risks, such as volatility and severe downturns (e.g., the financial crises of 2000 and 2008, and the inflation and recession experienced in 2022). Alternatively, IUL policies have a 0% floor, meaning their account values do not decrease due to negative market returns. Additionally, IUL grows when the market performs well because its account values are linked to the percentage growth of one or more market indices (excluding negative returns). Another significant advantage of IUL is the leverage provided by the insurance death benefit, which takes effect immediately upon purchasing the policy. If the insured individual were to pass away in year 1 of the policy, the policy beneficiary would receive a substantial insurance death benefit. In comparison, if you start saving in a standard pre-tax or post-tax Roth plan and suddenly die in year 1, your beneficiary would only receive the initial investment made in year 1, along with its growth, which may not be significant. Furthermore, IUL policies often include accelerated benefits (or living benefits) based on the death benefit, which can be accessed by insured individuals who are chronically, seriously, or terminally ill. Lastly, IUL policies do not have RMDs. Additionally, IUL (and life insurance in general) can be owned by an irrevocable trust for estate and legacy planning purposes.
With a time horizon of 10-15 years or more, building wealth using IUL is typically a wise decision.
Visit the Law Office of Thomas J Swenson to learn more about estate and legacy planning, wealth building, and asset protection.
Add Comment