How much interest or compounding will you earn in the year before you retire? That is, what will be the amount of compounding you will see in your assets the year before you retire?
Back in 2018, we wrote an article on the marvel that is compound interest. One of the key points of that article was the importance of beginning soon to set money aside. It’s not so much the amount of money being sent into your future as it is the discipline of sending money ahead to grow for its future delivery.
Too often, individuals say something like, “I’m really going start getting serious about saving for retirement! I’m going to start putting money in my 401(k) … next year.” Great idea. Unfortunately, every year they wait costs them more than just the contribution they were going to make in that year.
They’re ignoring the compound earnings in their account in that last year before retirement. Often, the difference in waiting one year can be literally $50,000 – $100,000 in that final year of compounding. That’s the true cost of waiting.
For example, the most common illustration of the marvel of compound interest comes from starting to save for retirement at age 25 or age 35. If you were to put $386 each month into your IRA at age 25, assuming normal stock market returns of 7%, you would have $1,019,000 at age 65. If someone waits just 10 years to start – age 35 – and contributes the same $386 a month, they’ll have just $473,656 by age 65.
I have used this example countless times over the years, but recently, one of our clients said, “R. J., that’s a great explanation, but I’m not 25 OR 35. I’m 55! What are my options?”
Well … I have good news for you, friend. If you only have 20, 10, or even 5 years to let compound interest work for you, here are several ideas where we can help you supercharge your retirement assets … Imagine That™!
Catching Up - With Interest!
One way to make your money work harder and help make up for lost time is using some “tax judo.”
For example, most people pay ordinary income tax or capital gains tax on their investment earnings or when they liquidate assets. What if you instead buy and sell assets inside a tax-sheltered structure like an IRA or Roth IRA? There are even certain other types of tax-favored structures that have a philanthropic twist as well!
But first … a quick refresher on IRAs in general:
- IRA contributions are tax-deductible and have no taxes on the gains within the account. You will pay income taxes on the distributions when you start taking them. And the government will force you to start taking distributions once you reach the age of 73.
- Roth IRAs are funded with after-tax dollars (same limits as a regular IRA), so no deductions for money contributed. The money in the account does grow tax-free however. Assuming you hold the account for at least five years or to the age of 59 ½ (whichever is longer), there are no taxes on the distribution. Additionally, Roth IRAs do not have a forced withdrawal age or “Required Minimum Distribution” amount.
If you want to dive into the details of IRAs, click here for a great article from Investopedia.
But there’s a good chance you already know the advantages of investing your hard-earned money into a retirement account.
So what else could you do?
How About a "Formula 1" Life Insurance Contract?
Huh? A what? Life insurance contract? Isn’t that just something for somebody else … like when I die?
Well … OK. There IS that. But this is a hybrid type of life insurance contract that is not your grandparents’ life insurance, just as a Formula 1 race car has an entirely different engine and suspension than your SUV!
These contracts are structured to build as much cash value as possible using various types of indexes (such as the S & P 500 Index) and … doing it as quickly as possible. Think of it like adding nitrous to a street racing car.
Certain types of contracts (the ones we recommend to clients) even have downside protection in the event that the index returns are negative. (Like 2022, when the S & P Index dropped -18.11%, even including dividends.) That year, the insurance company capped the loss at 0%.) So even when the index turns negative, the life insurance contract credits a 0% return for the year.
There are three big advantages:
- You have a death benefit in case you kick the bucket before you plan to
- You have living benefits in case a health emergency rears its ugly head
- You can use the cash value as tax-free income to supplement your taxable income from an IRA or 401(k)
Let’s focus on the last one. How can you make withdrawals from a life insurance contract be non-taxable? The first way (as long as the contract has been in effect for 15 years or longer) is to begin taking withdrawals of the contributions you’ve made thus far into the contract. Easy peazy! You’re getting back the money you put into it. The IRS requires you wait 15 years before you do that.
What comes next? As long as the contract has been properly designed, even the investment returns inside the contract are not taxable to you as income as long as your life insurance lasts longer than you do! Should your life insurance contract lapse before you die, there will be ordinary income tax paid on the growth in the contract. With these contracts designed to provide income, however, there are special features to make sure the coverage survives you.
Another benefit for high-income earners is that the tax-free income from these “Formula 1” insurance contracts is that it does not affect your Medicare premiums or Social Security taxes. It does not bump you up an income tax bracket. It also lets you leave your retirement accounts alone in those years when the market has its inevitable negative returns. It gives your money breathing room to recover.
The cash value only takes 10 – 15 years to grow to a meaningful level, depending on the premium contributions you are making.
Have You Considered Rental Property?
Rental income from real estate investment property is particularly attractive in this current investment environment. Most, if not all, of the income is tax-sheltered because of a “pro-rata share” of depreciation or interest deduction.
One word of warning. With higher interest rates right now, it’s not a great time to borrow money against your home to buy rental property. You could instead piggyback on an institutional borrower and ride the “bullet train” toward an additional income stream without the risk of borrowing the money yourself and all that it entails. One of the other advantages is there is no property management responsibilities.
Rental property is a great asset for your investment portfolio, especially when using after-tax dollars. That said, it is possible through a self-directed IRA to invest into real estate projects like the above. (By the way, institutional funds investing in apartments are “having their day in the sun” along with senior housing and self-storage facilities.)
If you’d like to chat about what that means more specifically, shoot us an email or give us a call!
Do You Have A Health Savings Account?
Some have dubbed a Health Savings Account (HSA for short) as the “perfect” financial benefit for most taxpayers. “Why is this?” you ask.
- A Federal income tax deduction for contributions
- Perhaps a tax deduction in your state, although NOT in California!
- A place to grow your money without tax
- An opportunity to withdraw contributions and earnings, including growth, without incurring Federal income tax when used for healthcare expenses
All you need is a “High Deductible Health Plan” defined in 2023 as being a mere $1,400 out-of-pocket for an individual and $2,800 for family health insurance. With that in place, you can then set up a Health Savings Account through almost any major brokerage. (We use Fidelity, but many other good ones exist.)
In 2023, you can contribute up to $3,850 ($7,750 for families.) If you’re 55 or older, you can add another $1,000 on top of that! A couple both age 55 and up would get to contribute an extra $1,000 each.
“But wait,” you say. “Aren’t withdrawals only allowed tax-free for medical expenses, but taxable with a penalty if you use the funds for something else?”
Ding, ding, ding … right, you are!
But here’s the point. While I would love for each and every one of us to go the rest of our lives without needing to visit the doctor (I have yet to meet anyone who is a big fan of getting poked with needles,) it’s unlikely.
How unlikely? The 2023 Fidelity retirement health expenses study estimates the average couple turning 65 today will spend over $315,000 out-of-pocket on medical expenses during their retirement years. And that’s just the average.
So, having money in a pre-tax healthcare bucket is just where we are getting started! Wouldn’t you rather pay for those medical expenses using tax-free dollars?
How Do We Make Our Money More Aerodynamic?
Another way to supercharge our 55-year-old’s money is to make it more aerodynamic. That is, the less “tax drag” there is on our money, the more efficient it will be in accumulating the amount we will need to get to the Winner’s Circle of retirement.
How do we make our money more aerodynamic? By making it more tax-sheltered through the use of certain types of investment “vehicles.”
What in the world am I talking about?
Have you heard of something called a Delaware Statutory Trust, or DST for short? (And, no – you don’t have to live in Delaware to buy it!)
Just like any high-performance race car, this one has more moving parts, and you probably shouldn’t/couldn’t build it yourself. An example would be making an investment in something that generates income that’s tax-sheltered. One such example often generates 5½% – 6% annualized income, paid monthly, and largely (if not completely) Federal and State tax-free.
In addition, at the liquidation of the asset, there is, in most cases, an additional 5-8% appreciation that qualifies for long-term capital gains. Or, using a special tax-deferral section of the IRS tax code, we can defer the tax completely until some point in the future.
Give us a call if this sounds interesting because it’s a whole other article on its own.
What If You Could Receive Tax-Favored Income & Do Something Nice For Others Simultaneously?
One of my favorite win-win-win-win-win-win strategies is what I call the “Capital Gains Alternative Trust.”
What if you could…
Win #1 – Place appreciated assets in a special trust and sell them without tax.
Win #2 – With this larger amount of net assets, you will receive more income than if you sold the assets, paid the taxes, and reinvested the proceeds to generate income.
Win #3 – And what if you could create an income stream for you and your heirs (if you wish) up to a total of four generations?
Win #4 – Get a tax write-off for the year of the asset contribution with tax deductions for as many as six years.
Win #5 – Defer tax on any earnings that the trust doesn’t pay out?
Win #6 – Transfer anything remaining in the trust to the charity(ies) of your choice when the last beneficiary kicks the bucket. (This could be your own family charity!)
What’s not to love?
Whether you’re 25, 35, or 55, the key to getting into the Winner’s Circle of Retirement begins with putting money away consistently. (It’s the Indianapolis 500 is not the Indianapolis 3!) It’s 500 consistent laps, staying alert, refueling, changing tires, and watching for opportunities to pull ahead.
We shared just six ideas to make your money work more efficiently, whether your choice of wheels is a Volkswagen Beetle or a Formula 1 racer.
- Using tax-favored vehicles for expenses you know you’ll have (like healthcare)
- Diversifying assets into tax-sheltered classes like rental real estate
- Using non-traditional income generating vehicles like life insurance
- Paying less tax on the same amount of income
- Eliminating taxes on the sale of appreciated assets
Even if you’re 55 or 60, a supersonic jet can still get those 500 laps in and reach the Retirement Winner’s Circle!
We’re part of your pit crew here to take a look under the hood, check the tires, and see what we can do to get you over your finish line to pop the champagne while it’s still cold and bubbly … Imagine That™!
Imagine That™! is a complimentary monthly newsletter provided by Wealth Legacy Group®, Inc. that addresses various topics of interest for high-net-worth and high-income business owners, professionals, executives and their families. Sign up to receive our monthly newsletter here.
R. J. Kelly, Wealth Legacy Group®, Inc. – August 2023
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