Why is tax-free retirement income imporant?
The following paragraph is from a report from the United States General Accounting Office to the Chairman, Committee on Finance, US Senate, and the Chairman, Committee on Ways and Means, House of Representatives on the Tax Treatment of Life Insurance and Annuities. Sorry for the long title, I didn’t name it but it does sound official.
If a policyholder borrows the inside buildup from his or her life insurance policy, the amount borrowed is considered a transfer of capital, not a realization of income, and, therefore, is not subject to taxation. This reasoning is in accord with tax policy on other types of loans, such as consumer loans or home mortgages. These loans are merely transfers of capital or savings from one person to another through a financial intermediary. The ability to borrow against a life insurance policy means that the interest income that is supposed to be building up to fund death benefits can instead be a source of untaxed current income. If the loans are not repaid, the inside buildup will never be taxed; death benefits will simply be reduced by the amount of the loan. Thus, policyholders have the use of tax-free income for purposes other than insurance at the expense of reduced death benefits for their beneficiaries.
Basically, the growth inside your policy can be accessed as retirement income on a tax-free basis according United States tax law as long as it meets the constraints of being considered a life insurance policy. With the INC Wealth Strategy, we want to buy as little insurance as possible with as much money as the IRS will allow thus building as much cash value as possible and still be considered life insurance. This way the paragraph from the United States General Accounting Office still applies. We have many examples of how our clients’ policies will generate tax-free retirement income for them. Since everyone’s outcome is different based on their age, rating and the amount of money they can put into their policies, contact us to see how we can help you plan for tax-free retirement income too.
Why is tax-free retirement income important? It’s important to compare the INC Wealth Strategy to retirement income from other vehicles, such as a 401(k) and IRA. Retirement income from a 401(k) and IRA work in basically the same fashion as each other because the dollars you put in during your career are pretax dollars. This means you have to pay the taxes at your tax rate when you take the money out of these accounts — your future tax rate. The premise is that you will be in a lower tax bracket when you retire than you are now. For some people this may be true, but not if you plan on being successful during your career. In addition, most people do not have the same tax deductions at retirement age that they had when they were younger. Some retirees have paid their mortgage off by retirement so they do not have a mortgage expense deduction. Their children are likely grown so they do not have the child tax credit anymore. Considering your current and future success, the lack of future tax deductions and the national debt, where do you see your tax rate in the future? Assume you are in a 25% tax bracket today and put $10,000 into an IRA. If you are successful you could be in a 40% tax bracket in the future, meaning you would pay an additional 15% in taxes than you could have paid. Imagine if the $10,000 in your IRA actually grows (which is up in the air, as we know from 2007 and 2008) to $100,000 then you will pay $40,000 in taxes! Not only will you be paying at your current rate you will be paying on your current volume. Once again, volume is more important than rate. You could have paid the $2,500 today and put the $7,500 remainder to work for you and have better results.
If you are in a 40% tax bracket at retirement and need $100,000 for retirement income then you would need to pull $167,000 out of your account to net $100,000 after taxes. Imagine every year pulling out $167,000 from your retirement accounts. Will you run out of money eventually? Will you have to reduce your lifestyle? How much money will you need for retirement considering your tax situation? Do you trust your investments to perform like that?
Because your retirement income from your policies is tax-free, if you need $100,000 you borrow $100,000. Not only are you not reducing the amount of money continuing to earn for you by $167,000, you're not reducing the amount of money earning at all. Whereas with a 401(k) or an IRA you would be reducing the amount of money earning by $167,000. If you pull that money out at age 65 and live to be 90 years old, you would be giving up 25 years of growth on that money.
There are also creative ways to generate additional retirement income outside your policies. As you know, I have two daughters. In 20 years or so they will likely be considering buying their first house. They could go to a traditional bank like almost all their peers to get a mortgage and pay a tremendous amount of interest over the life of that loan. Instead, I will loan them the money for their house at the same terms a bank would have loaned it to them. Their mortgage payment will supplement my retirement income and at the end of my life they will receive a death benefit, which will essentially reimburse them every dollar they ever paid for their house. Not only will this create additional retirement income outside my policy, it will also keep the money in the family. Yes, I will expect my daughters to pay their mortgage. Part of the INC Wealth Strategy helps teach future generations how money works and that you must pay your loans back. After all — Interest is.