Tax-Free Income In Retirement: Why Is It Important & How Do You Do It?

retirement and tax planning in san diego californiaI recently listened to a sobering webinar by David McKnight, which inspired this month’s newsletter. Mr. McKnight is the author of The Power of Zero: How to Get to the 0% Tax Bracket and Transform Your Retirement. His book addresses why we should be securing tax-free income when we retire and discusses the available tools to enjoy tax-free income in retirement.

The U.S. Economy is Heading Off a Financial Cliff

David McKnight’s book follows in the footsteps of the mounting evidence compiled by former U.S. Comptroller General, David Walker. Mr. Walker was the nation’s top accountant from 1998 to 2008 and served under Presidents Bill Clinton and George W. Bush. He ran the Government Accountability Office, which audits the government’s books. While still in office in 2007, Mr. Walker shed light on “the dirty secret in Washington everyone knows” when he appeared on the 60 Minutes TV show. The dirty secret was that the most serious threat to the U.S. is not from outside, but from within … from our own fiscal irresponsibility.

Mr. Walker said we were suffering from a “fiscal cancer” and if not treated, it will have catastrophic consequences for our country. The fiscal cancer results from the massive entitlement programs which are becoming increasingly unaffordable – such as Social Security and Medicare. People are living longer – having fewer children – and we have far fewer workers paying in versus those taking income out.

For example, when Social Security was initially set up in 1935, 42 workers paid in for every 1 retired worker. Retirees received benefits for 2 years on average. According to the Social Security website, as of 2013, there were 2.8 workers paying in for every 1 worker retiring, and it is expected to be only 2.1 workers paying in by the year 2040. And, instead of receiving benefits for only 2 years, retirees today are receiving benefits for 30+ years, on average. There are simply not enough wage earners to pay for the Social Security benefits of the Baby Boomers.

In addition, we Baby Boomers are crashing the system at the rate of 10,000 retirees per day! And, since Boomers represent nearly 20% of the American public, the huge number hitting Social Security and Medicare systems will have a direct impact on the systems for those coming afterwards. 78 million Americans will become pensioners and medical dependents of the U.S. taxpayer by 2028. And, in June of 2018, the trustees for the Social Security system reported that the program’s cost will exceed its income for the first time since 1982 – forcing the program to dip into the trust account to cover benefits.

While the increasing numbers of people receiving Social Security benefits is a concern, the more alarming issue is health care costs. According to Mr. Walker, the Medicare situation is five times greater than the Social Security issue. Medicare costs continue to increase because people are living longer, and medical costs continue to rise much higher than inflation.

A more recent interview last year with David Walker indicates that nothing is being done to solve the issue and, in fact, it is getting worse. The tax and spending legislation approved in the last year or so will double the federal deficit. He referenced a Congressional Budget Office (CBO) report, which predicts the federal government will spend more on interest than it spends on Medicaid beginning next year! And within five years, the federal government will spend more on interest than it does on national defense. Mr. Walker also said the Social Security Trust fund will be completely gone by 2031!

How to Protect Yourself From the Federal Financial Cliff?

The federal government will have to eventually address the fiscal challenges we are facing or it will go bankrupt. And, not attempting to be political in commentary, but how can the U.S. government possibly provide universal healthcare to everyone given the above facts? While reforming Social Security, Medicare and Medicaid will be an absolute necessity, it seems increasing tax rates will be an unpleasant requirement as well. Some experts are warning that tax rates could even double from our current, historically low rates.

People’s retirement savings are at risk due to the threat of much higher taxes in the future. How do we protect these retirement savings? David McKnight discusses two options in his book, The Power of Zero:

What are the Benefits of a Roth IRA?

  • Tax-free growth and withdrawals—a Roth IRA provides tax-free growth potential and withdrawals, which can help minimize taxes and maximize retirement savings. In a Roth IRA, you contribute money which has already been taxed (“after tax” dollars) into a retirement account where it will remain tax free when you withdraw it, as long as the money has been in the account for at least 5 years, and you are at least age 59½ or disabled.
  • No required minimum distributions—unlike a traditional IRA, which requires minimum distributions when you reach age 70½, the Roth IRA has no such requirement.
  • Avoid Social Security tax—you may wind up with a break on Social Security tax as compared to a traditional IRA. The annual distribution a person receives from a traditional IRA increases their annual taxable income, which can cause up to 85% of their Social Security benefits to be taxable for each year of their retirement. It can also bump them into a higher tax bracket.
  • Eliminate or reduce the Health Care surtax—Roth IRA distributions do not increase the “modified adjusted gross income” on your tax return and therefore can eliminate or reduce the 3.8% Health Care surtax on incomes above a certain level. Traditional IRAs do receive this benefit.

What are the Benefits of a Life Insurance Retirement Plan?

  • “Investment grade” insurance—the Life Insurance Retirement Plan is basically like a life insurance contract, but it also has a component where you can buy stocks or mutual funds. These special life insurance contracts are considered “investment-grade” … which have minimal amounts of death benefit – and maximize the earnings growth inside the contract. (Note that surrendering the contract prior to death can cause the earnings to be subject to tax, and at ordinary income tax rates. The key is to keep the contract in effect until death. Some insurance companies provide a feature that will not let the contract “crash and burn” prior to death occurring – thus avoiding this danger.)
  • Earnings grow tax-free—contributions are after-tax, just like a Roth IRA, and earnings grow without tax.
  • Tax-free distributions—distributions can also be taken without income tax as long as a certain amount of survivor benefit remains intact.
  • Long-term care benefits—not only can these contracts provide supplemental income, but some of the newest contracts can even add a benefit to reimburse the insured for long-term care expenses as well … something not permitted in an ordinary Roth IRA.

Conclusion: Protect Your Retirement Savings From the Higher Taxes Likely Coming Soon

Since it is nearly inevitable that tax rates will substantially increase in the future, protecting your retirement savings should be a prime concern. Investing in a Roth IRA is an easy way to ensure your retirement savings will have no taxes when you withdraw them in your retirement years. If you have retirement savings in tax deferred accounts, such as a traditional IRA, 401(k), etc., it may be worth considering a conversion to a Roth IRA. (Call or email us if you would like to see calculations for this.) If considering a Roth conversion, please see our October 2015 “Imagine That™!” newsletter on this topic.

The second option, using an “investment grade” insurance contract is another way to have zero taxes on retirement distributions from the contract, and has some unique benefits that the Roth IRA does not have.

If interested in learning more about how to protect your retirement savings from the fiscal cliff which the federal government will eventually have to face, please contact us. We can help protect your retirement savings from the higher taxes that will eventually be put in place … “Imagine That™!”

Please note: We have a 12-part video series which will teach you how to avoid the common mistakes people make in their retirement planning so can retire successfully. If you want to receive it to your mailbox, please send an email to 

Imagine That™!”

Written by R. J. Kelly – January 2019

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Photo by Sam Wheeler on Unsplash

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