Episode 16: Taxes in Retirement (Continued)
In this 4-part series on taxes in retirement we have been highlighting the concepts of Author David McKnight’s bestselling book titled “The Power of Zero” and his follow-up book “Look before you LIRP”
On this week’s show, we are going to finish up our discussion on the life insurance retirement plan (LIRP.) So far, we have made the case that there’s only one LIRP that is best suited to help you potentially get to a 0% tax bracket in retirement.
There are other life insurance policies that have some compelling features, but when it comes to planning for a 0% tax rate in retirement, nothing compares to the IUL.
Our discussion in this series is regarding a lower or even possibly a 0% tax rate in retirement. We’re sharing ideas on how you could potentially achieve that, but it takes a lot of planning and not all L I RP’s are created equal!
Disclaimer: Please do not take advice from me on this show. As a licensed Fiduciary I am only allowed to give advice to clients. Unless you’re a client I can’t give you advice because I don’t know you. Think of this as helpful hints and education only! And please, before implementing any information or ideas you hear on this show always consult your legal adviser, your tax adviser, and your financial adviser.
(2:30) Practical Planning Segment: As usual I am joined by my co-host, Joani Gursky!
Last week we started our discussion on the life insurance retirement plan and explained the basics of how they work and what to look for when you’re out shopping for a L IRP. Remember, this is a long-term arrangement and is not something to take lightly or rush into. The author, David McKnight refers to a life insurance retirement plan as a marriage and he says I quote, “nobody wants to get married only to find out years into the relationship that their spouse is not as advertised.”
So even after all those considerations that we talked about last week there are still items that separate good LIRP’s from bad ones. The first one being guaranteed 0% loans. Remember, this is how we are actually taking income from these policies. So, this may be one of the single most important components in your L IRP.
As we discussed last week, all loans from your life insurance policy are tax free that’s the nature of a loan. Right? When you borrow money from a bank for example, you’re not charged income taxes on that loan. That’s the same concept with the LIRP.
All loans are tax-free but not all loans are cost free. When you take a loan from your LIRP, the insurance company takes money out of your growth account and deposits it into a collateral loan account and actually credits you a stated rate of interest
So it’s collateral. At the same time, they actually cut you a check from their own coffers and charge you a stated rate of interest at the same rate that they charge you. That’s how we get to tax-free and cost free.
Does that make sense?
So that keeps it very simple and zero cost. Having said this there’s only few companies that guarantee these two numbers to always be equal. Some companies will guarantee the difference to be very small. This is where it makes sense to closely examine the loan provision of the policy before making a long-term commitment.
(7:40)The next important quality that separates a good LIRP from a bad one is having a stable index cap rate.
Have you ever heard of a credit card company that offers a “teaser rate”? They might offer you some really low introductory rate that will increase dramatically the following year. This is often called a teaser rate. Be very careful when looking at rates!
Well, the same type of caution should be exercised when looking at the index caps on the LIRP. Most ‘A’ rated insurance companies offer caps in the range of 12% to 15% per year. Cap rates in this range allow you to participate in the upward movement of the stock market while the same time enjoying downside protection.
Additionally, you’ll want to look at the history of how the company has changed their rates overtime. You don’t want to company that has a history of starting out with a high cap rate only to decrease that cap rate dramatically in the following years. This would of course affect the results and the returns on your LIRP.
(10:20) The next important quality that separates a good LIRP from a bad one is that the insurance company is financially stable.
You want to make sure that you have a financially stable company that is going to offer you a LIRP. Be very careful, you may find a LIRP that has all the positive attributes we’ve discussed previously, but they may be offered by a company that is financially unstable. On the other hand, there are many financially stable companies out there that offer the LIRP with all the attributes we’ve discussed.
So how do we judge whether a life insurance company is truly financially stable? There are four main organizations that rate life insurance companies: Moody’s, Standard & Poor’s, a.m. best, and Fitch. Each one of these companies has a different method to assign their ratings. For example, an A+ rating from a.m. best is the second-best rating but with standard and poor’s and Fitch an A+ rating is the fifth best rating.
There are also independent ranking services that will average all the rankings of all the companies rated by the organizations mentioned earlier. Comdex averages the rankings of all the companies. And they’ll rank them from 1 to 100. It’s critical you limit your search to LIRP companies that have a COMDEX rating of 80 or better, in our opinion.
(13:40) The next important quality that separates a good LIRP from a bad one is having an over loan protection rider.
Historically, the one thing that could get you in trouble with a LIRP in the future is if you run out of money in the policy, it could lapse, and all those withdrawals would be declared as taxable.
In general, if you don’t have at least one dollar left in your growth account when you die, it will come due in one year. That sounds really scary. Now IUL’s are impervious to market loss but that alone does not guarantee protection against this pitfall.
Within the last 10 years, some insurance companies have responded to this possibility by adding a very powerful provision to the policy called an over loan protection rider. The rider simply says that if the insured has held the policy long enough (let’s say 10 years) and the cash value falls low enough due to excessive withdrawals/loans and the insurance company will give you an option of activating the over loan protection feature.
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When this happens, the insurance company reduces the death benefit to a point where the remaining cash value within the policy pays the policy up in full. At this point, you no longer have the ability to take money out, but you avoid ever having to get a huge tax bill for effectively outliving your LIRP.
The net effect of this rider is to completely neutralize the single greatest danger in your LIRP.
(16:00) Okay, so those 4 items, along with the characteristics we mentioned last week, are the most important things to look for when you’re creating your LIRP laundry list! Now let’s switch gears a bit and talk a few of the myths regarding IUL policies and LIRP’s:
Number one: be wary of overly optimistic IUL illustrations. When an advisor gives you a recommendation for an IUL, they’re legally required to show you an illustration. That illustration will have to be signed by both you and the adviser. Some critics suggest that the rates of return shown on these illustrations are too high and unrealistic. Most highly rated insurance companies will verify these rates of return for well over 15 years. Some critics will say that 15 years is not enough. So, insurance companies also conduct back testing, and some go back to 20, 25, 30 or even 40 years. What I’ve noticed with the illustrations is that a highly regarded insurance company does not illustrate the actual historic rate of return. They actually illustrate something far less. Although they cannot guarantee that that rate of return will be maintained but comparing it to a 25-year average they are actually illustrated much lower than the 25-year average. Number two: flexible index caps should have you thinking twice about IUL. And we talked about this earlier that most companies give caps somewhere in the range of 12 to 15%. But they do reserve the right to lower these caps. Therefore, it is good to get an historic history of how the company has changed the past. But it’s interesting to note that even in the wake of the financial crisis of OA and 09 some are you well companies only lowered there by 1%. The bottom line is: make sure you look for a company that has a great history of maintaining caps Number three: avoid IUL’s because of nonguaranteed insurance expenses. On every illustration you will find a guaranteed column listed. This guaranteed column shows the highest possible expenses of the policy along with the lowest possible rate of return. It makes the illustration look rather dire because it fails every time. Could the worst-case scenario happen? Maybe. Is it likely to happen? Probably not. The reason is simple: People have the right to move their policies. They could shop around, and they could do a tax free 1035 exchange into a different company and an entirely different policy for this reason most highly regarded insurance companies do not mess with the insurance rates that often. Number four: IUL’s have high fees. Well we addressed this earlier let’s talk about it a bit more Just because a financial guru on some website says the IUL has high fees doesn’t make it so when fees are averaged out over the policyholder’s lifetime the typical IUL policy is very cost-effective way to build tax-free wealth while at the same time providing death benefit and long-term-care protection. Again, you must compare it to an alternative plan. Number five: you risk a huge tax bill should you’re IUL run out of money before you die. As is the case with most myths this want has a small amount of truth but is shrouded in mostly false statements. The truth is the IRS does require that any life insurance policy have at least one dollar of cash value at the time of death or it loses its tax-free protection If you violate this role you risk receiving a 1099 on all the game in the cash value above the cost basis. This would be a nightmare scenario. However, there are several ways to ensure that this never happens. I’ve mentioned numerous times in this podcast that this may be considered as part of an overall plan. This should not be your only plan. And this may not make sense for some folks at all. Secondly any good well regarded IUL policy is going to have an overload protection rider which would protect the policy from lapsing and running out of cash value. This criticism is much more relevant to Variable LIRPs that are tied to the stock market where combinations of market downturns and ill manage distributions send policies into a death spiral. We mentioned variable life insurance policies on last week show as variations of the LIRP to avoid!(26:30) Closing Segment: Establishing a plan to tackle the uncertainty of future tax rates takes a lot of thought!
In this series we discussed the unfunded obligations of our federal government that most likely can only be met by a raise in taxes. I guess the other option would be to decrease expenses but that doesn’t seem to ever be on the table.
We also discussed the fact that in retirement many of your tax deductions are gone, many of our clients have already paid off their existing mortgage so there’s no mortgage interest adoption, the kids have moved out of the house so there’s no child tax credits, they’re no longer working so they’re not investing in their IRA accounts any longer so there’s no tax deductions they’re. Some of those tax deductions during your working years could’ve amounted to 50 or 60 K per year. Oftentimes, when you’re retired, you’re only left with the standard deduction.
We also explored the history of tax rates and discovered that we are currently in one of the lowest tax rate environments since the beginning of the tax code. In other words, tax rates have a lot of room to go higher. We just don’t know the future of tax rates, so it makes sense to have a plan in place and be proactive.
We then discussed an understanding of how our money is taxed and we talked about organizing our assets into three tax buckets, Bucket number one was the bucket that is taxed now. You receive a 1099 every year. Bucket number two was the taxed later bucket or tax-deferred bucket 401(k), IRAs, all that money will be taxed in the future at some time. And bucket number three was the tax-free bucket which we discussed as a Roth IRA account and the LIRP.
When creating a plan to tackle potentially higher tax rates in the future, you want to be proactive and explore the idea of tax diversification. This can give you the ability to choose which bucket to take distributions from in a very tax effective manner. The alternative is being forced to take distributions out of the tax later bucket therefore incurring a huge tax burden in the future depending upon the size of that bucket.
You may have some time to start building the tax-free bucket and possibly shift some assets from the tax-deferred bucket to the tax-free bucket prior to age 70 ½ when the IRS comes calling.
(30:30) Being proactive in tax planning takes a lot of thought, it takes a lot of conversations with a qualified adviser and it requires taking action! I encourage folks to start thinking about this, especially those listening that are in their early 50s and early 60s because you have time to do some of this proactive tax planning before hitting that magic age of 70 ½.
Okay so that’s it for this series: taxes in retirement- the power of zero! Feel free to email us with any questions you may have about this topic… I would love to answer those on a future Q&A show.
Speaking of Q&A shows… that will be our next series so we highly encourage any and all questions you can email those questions directly to me to jeff@mfswealth.com you can also give us a call at 855-97-COACH. We can answer any and all retirement questions about taxes, Social Security, investment management, long-term-care, you name it!
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