The ideal investment opportunity would have the following three attributes:
- tax deductible going in
- tax-free growth
- and no tax coming out.
That would be ideal, but unfortunately, that kind of investment opportunity does not exist!
Most qualified retirement accounts satisfy two of these three features. For example, in a 401(k) or a traditional IRA, your contributions are tax-deductible, investments grow on a tax-deferred basis, but the funds will be taxed when they are disbursed to you in retirement. Alternatively, in the case of a Roth IRA, investments grow on a tax-free basis and the funds are disbursed tax-free in retirement, but contributions are not tax-deductible.
Since we can’t get all three features in one type of account, how do we choose which retirement vehicle to use? Before answering that question, let me challenge a common wives’ tale… although we often hear that when you retire you will be in a lower tax bracket, I rarely find that to be the case with my clients. Professionals and business owners are frequently in a higher tax bracket after they retire. And, if you are likely to be in a higher tax bracket during your retirement, the best option may be to pay taxes on the money you use to initially fund your investments, have the funds grow on a tax-free basis and have the funds disbursed tax-free when you retire. A Roth IRA would be one possible vehicle to achieve this goal.
A significant obstacle with Roth IRAs, however, is that there are maximum contribution limits and income restrictions that are subject to change each year. The maximum contribution to a Roth IRA in 2014 is $5,500 if single or head of household and $11,000 if married. If you are over age 50, then the maximum limit increases to $6,500 for single or head of household and $13,000 if married and both spouses are over age 50.
Income restrictions for Roth IRAs can also impede your ability to invest for retirement. If you are single or head of household and earn more than $114,000 or are married and earn more than $181,000, then your maximum contribution limit in 2014 decreases. You are barred from contributing to a Roth IRA in 2014 if you are single or head of household and earn more than $129,000 or are married and earn more than $191,000. Further, funds must be left in the account for at least five years, and the participant must be over age 59½ to withdraw without penalties or taxes.
So, what can you do to create a bucket of funds without income restrictions or a ceiling on contributions? The answer might surprise you! …
One of the last true vehicles to invest on a tax favored basis is life insurance. With a properly designed life insurance contract, the investment portion grows on a tax-deferred basis, funds can be accessed prior to age 59 ½ for an emergency or opportunity without penalty, and the funds do not have to be left in the account for five years. Further, the contract can be structured to provide predictable retirement income. Unlike tax-free income which affects the taxation of your social security benefits as well as the cost of your Medicare part B premiums, withdrawals and loans from a properly designed insurance contract avoid this pitfall. In addition, any death benefit paid to your family will be free of income tax, capital gains tax, probate and, if properly structured, federal estate taxes.
My preference today is to use a life insurance contract that only participates on the upside of the market, not the downside. Most people have the perception that life insurance is expensive. Surprisingly, an insurance contract properly designed to fund retirement can cost less than your average mutual fund account over time.
Recently a few of my clients, doctors in a local practice, came to me for recommendations on their retirement funding. They had made the maximum contributions to their 401ks and were still not saving enough for retirement. They did not qualify for Roth IRAs due to their income. Overfunding an insurance contract provided them with the vehicle they needed to meet their retirement goals.
Remember, when it comes to retirement planning, you want to be tax-wise, but not necessarily tax-driven. Because you can only “guesstimate” what your tax rate will be when you ultimately retire, making retirement planning decisions solely on income tax implications may not be an effective strategy. The goal is to have an understanding of the tax implications of retirement planning as one of many factors that influence your decision-making process. To discuss comprehensive retirement planning or if you are interested in learning more about overfunding a life insurance contract for retirement planning purposes, please contact me.
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Written by R. J. Kelly – May 2014