New Way to Look at Retirement Income Savings
Retirement Income Savings
Having enough disposable income in retirement is always a sensitive topic. Most of the time, people don’t want to talk about Retirement Income Savings just to avoid the anxiety that comes with it. Many of my customers worry the market will go down at the most sensitive time, just after starting their retirement. Many also note that reliance on the most commonly used tax-advantaged retirement accounts has limitations on contributions and restrictions on distributions. They are concerned about current conditions of the country that will almost certainly lead to higher tax rates in the future. I’ve been fortunate to learn about a product that can avoid these issues.
David Knight, in his book, The Volatility Shield, shows an example of a person who saved all his life for retirement. He was able to put away $3 million and was sure that it would keep him secure financially for at least 35 years without worry. His bad luck was that he started in 2000, right before the Dot.Com crash. Having an initial three bad years, while still taking out 4% of the initial value annually, emptied his account within 19 years.
Obviously things could have been different if that was not the year he’d started retirement or if he could have managed his distributions another way. But we can only know those things after the fact. There is no Magic 8-Ball that can tell us what will happen or when we should do what. Having at least a portion of your retirement funds protected against a downturn of the market could improve the whole experience of being retired.
Someone looking for retirement income to begin in as few as 10 years, who already has substantial tax-deferred savings, can enjoy much higher growth potential than CD’s through a Fixed Indexed Annuity, with no risk of loss for their safe money. This addresses the first worry about a market downturn, but there are still concerns about the cascading effects of federal taxation on net disposable income in retirement.
401k or Traditional IRA
Most people save for retirement in tax-deferred accounts like a 401k or Traditional IRA. The government wants people to save, so they provide incentives for these types of accounts. Chief among these is not paying taxes on contributions in the year income is earned, but rather deferring income tax on the account value and its growth until distributions are made. The government always wants its money!
To make sure these types of plans are used “appropriately” (in the eyes of our lawmakers), there are restrictions in place. First, there are limits on the maximum amount of contributions a person can make on a yearly basis. In 2020, that’s $19,500 for a 401k account and $6,000 for a Traditional IRA for those under 50. Catchup contributions for those 50 and over allow an additional $6,500 ($26,000 total) for a 401k and additional $1,000 ($7,000 total) for an IRA.
Second, there are rules about when retirement plan distributions can and must be made, with a few exceptions for hardships, large medical expenses, or first-time homebuyers. Distributions taken before age 59 ½ incur an early withdrawal penalty. Required Minimum Distributions must begin no later than age 72 (or age 70 ½ for those born prior to July 1, 1949) according to age-based percentages set by the IRS or else face a late withdrawal penalty. All distributions from tax-deferred retirement plans are included in Adjusted Gross Income (AGI) and thus figure into amounts subject to federal income tax.
Deferring tax during the income earning years is only advantageous on the assumption that you’ll be in a lower tax bracket during retirement. We may not be able to count on that. Based on current tax law, we have the lowest rates in the last 80 years even as government policies and crisis emergencies have created a huge national debt with enormous future obligations. This perfect storm creates a setting where there is every conceivable opportunity for future tax rates to be higher even for lower income amounts.
Income Related Monthly Adjustment
Many retired professionals are surprised to learn that they will pay higher premiums called the Income Related Monthly Adjustment Amount (IRMAA) for Medicare Part B and Part D when their tax returns from two years prior show household income greater than $85,000 per person for 2019($87,000 for 2020). Tax-free income sources don’t count towards that limit. Taxable income sources including Traditional IRA and 401k distributions, along with municipal bond interest payments and half of Social Security benefits (collectively “Combined Income”) determine how much, if any, Social Security must be included in taxable income.
A couple with $10,000 Social Security income and $50,000 from tax-deferred funds will include $8,500 of their Social Security benefits in taxable income and owe nearly $4,400 in federal tax because their Combined Income is over the $44,000 threshold for 85% Social Security taxability. A couple with $40,000 Social Security income and $20,000 from tax-deferred funds would only include $4,000 (50% of the $8000 of Combined Income over the $32,000 base amount for 50% taxability of Social Security) and owe $90 federal income tax. In this case, 2.5 times as much money generates about 50 times as much tax burden – a twenty-fold increase! Having a portion of your overall retirement income coming from a tax-free box can reduce the amount of Social Security subject to income tax.
Indexed Universal Life
Indexed Universal Life (IUL) is the product that could avoid all those issues. Like indexed annuities, IUL policies earn interest when a stock index increases, but preserve principal in the event of a market downturn. Someone with a decade or more for deferred cash-value growth can enjoy much more after-tax retirement income through tax-free loans from an IUL policy than through taxable distributions from a 401k or Traditional IRA.
An IUL plan is a permanent life insurance policy where the premium amount and death benefit are flexible. This flexibility allows the policy owner to pay additional premiums into the plan’s cash value beyond the minimum necessary to keep the life insurance in force. Allocations of cash value to indexed accounts receive interest crediting (typically on a policy anniversary) when the market index has positive movement, often subject to a cap, which serves as the “price” for not losing any account value when the index goes down over a measuring period. In my view, this is a fair trade-off to avoid ever losing value you’re depending on for retirement due to a market crash without time for recovery.
Retirement income distributions from an IUL plan take the form of policy loans against the death benefit and thus reduce the amount of tax-free life insurance ultimately payable to beneficiaries. This structure of a loan paid off at the time of the insured’s passing keeps all income received from cash-value earnings tax-free. Due to the fact that earnings on top of the owner’s basis in premium payments can be used tax-free, the government places a limit on how much additional premium can be put into an IUL plan and remain eligible for the desired tax advantage.
Expressed as a ratio of premiums to face amount, the 7-Pay Test requires that there be a “corridor” of difference between the death benefit and the cash value, especially during the first seven years or following any substantial change. Exceeding this limit with overpayments converts the policy to a Modified Endowment Contract (MEC) which would require treating withdrawals during the lifetime of the insured as taxable income. Well designed IUL plans structure the death benefit for maximum contributions to allow for the most efficient growth and tax-free income.
Indexed Universal Life Protects Retirement Income
An Indexed Universal Life plan’s cash value can avoid facing market loss at any time, has few limitations on annual contributions, and protects retirement income from an unsecure tax environment. IUL plans can be tailored to many needs and budgets. A personal evaluation is a great way to get started. Contact Senior Benefits of Georgia to set up a free consultation with one of our licensed agents and take the next step towards a more secure and productive future.