Most working Americans utilize their companies’ retirement plans. These are usually 401(k) s, or sometimes, 403(b) s. It is always a good idea to save in these vehicles because, the majority of the time, your employer is going to match at least a portion of what you put in. That’s an automatic raise of whatever they’re willing to match, usually anywhere between 3% and 7%. There are also tax-favored vehicles that allow an individual to contribute additional money towards their retirement. These are called IRAs, and act the same as the 401(k), just without the employer match.
Diving in a little deeper, there are two types of IRA and 401 (k).
- Traditional IRA/401(k)
- Roth IRA/401(k)
The main difference between these two types is when you get to pay your taxes on them. A traditional IRA/401(k) is using what financial advisors call qualified dollars. Qualified money is simply pre-tax money. If you made $100,000, and you contributed $10,000 into a qualified account, your taxable income for that year would then be $90,000. That qualified money then grows, tax-free, in your retirement account until you retire and start taking distributions. Once you start taking distributions (taking the money out after you retire), you then start paying the tax on what you’ve withdrawn at whatever the income tax rate is at that time. (More on this in a bit.)
A Roth IRA/401(k) uses after-tax dollars for contributions
If you made $100,000 and contributed $10,000 to a Roth vehicle, you would still pay tax on the $100,000 that year. As before with the “qualified” account, it will then grow tax-free. However, the big difference here, is that you don’t have to pay tax on your withdrawals because you already paid it way back when you initially invested it.
Spend less or earn more
So the question becomes: Why choose one over the other? Think about what tax bracket you’re in right now. Politics aside, we, as a society, are racking up a fair amount of debt that can only be dealt with in one of two ways – spend less or earn more. We haven’t proven that we are able to spend less very well, so it’s my guess (as is most experienced consultants) that we will need to earn more and the government earns more by increasing taxes. So by investing in a traditional IRA, you’re getting the benefit of lowering your taxable income this year, but you’re kicking the can down the road. Eventually, you will have to pay tax on that income when you pull it out in retirement and, with the current state of things, your tax bracket will almost certainly have to increase to pay for everything we’ve spent. Thus, you may want to take the tax hit now, while you’re tax bracket is still likely lower, and put that money into a Roth.
IRAs: contributions and penalties
There are a few other things to consider here such as penalties at every turn. You’re only allowed to contribute a certain amount to an IRA each year and as your income increases, the less you’re allowed to contribute until eventually, you’re no longer able to at all. In 2021, if you are married and filing your taxes jointly, you would be allowed to contribute $6,000 dollars as long as you and your spouse made less than $198,000 (Modified Adjusted Gross Income, MAGI). If you both made between $198,000 and $208,000, then you would be allowed to contribute less and if you made more than $208,000, you wouldn’t be allowed to contribute at all. There is a penalty if you put too much in (a 6% excise tax) and they’ll make you withdraw it.
There is also a penalty if you withdraw, or take early distributions as it’s called, from your IRA too early. These are meant to be retirement savings accounts and the government doesn’t want you to raid it until you’re 59 ½. If you do so before then, you will be penalized 10% that year and have to pay income tax on the distribution. If you’re older than 59 ½, then you’re allowed to start taking distributions without penalty, but if it’s a traditional IRA or 401 (k), then expect to start paying income tax on that amount the year you withdraw.
Finally, at age 72, you are required to start taking money out of your IRA. Remember, the government wants you to pay the tax on that money sitting in your retirement account, so they don’t want you to sit on it forever. These are called Required Minimum Distributions (RMD’s). If you fail to take the RMD or don’t take enough, there’s a penalty for that too! You will be required to pay the IRS a 50% excess accumulation penalty on the shortfall of what you were required to pull out!
So… with all that said, there is another way.
Cash-value life insurance can be a great alternative to a Roth IRA
Specifically, Index Universal Life, which offers participation in the markets without actually being invested in the market and the best part is, if the markets drop, there is a guaranteed floor allowing you not to lose anything that year. As the market climbs, your money grows. Essentially, you can enjoy upside market potential with downside protection! But, then, that’s not even the best part. Let’s talk about taxes.
Life insurance is afforded special tax treatment by the IRS. There are no income requirements nor are there any limitations on how much can be paid in but it still grows tax-free inside the cash value indexed account. There are also no tax penalties for withdrawing the money early, nor are they subject to the required minimum distributions. Similar to a Roth IRA or 401 (k), the amount you put in is done with after-tax dollars, grows tax-free, and in the end, can be distributed tax-free! These distributions are done in the form of loans. The insurance company will charge you a small percentage to “borrow” your cash accumulation in the policy and then turn around and continue to credit you the same amount on the money borrowed making it a net-zero loan.
The biggest argument we hear, especially from financial planners and wealth managers, is that insurance costs too much. You can get a better return from having your money actively managed. You have to keep in mind that these professionals make their money from having your assets under their management.
The fact is that the cost of insurance will almost certainly be less than the cost of taxation.
The life insurance carriers have designed a better product, and while there is a cost associated with the insurance, the tax savings, later on, will drastically outweigh those costs. There is a final added benefit here too. Index universal life is still a life insurance product. That means there is an income-tax-free death benefit that goes to your loved ones after you pass! Show me a mutual fund, REIT, or cryptocurrency that does the same. Diversification is key. No one is suggesting you put everything you have into a life insurance contract, but no one can argue about the tax benefits either.
Life insurance is a solid part of any sound financial plan. Its inherent tax-friendly components combined with market growth and a tax-free death benefit make offer advantages that investment vehicles simply can’t touch. Contact us for assistance in helping you round out your investment portfolio with an indexed universal life policy.