If 401(k)s and IRAs make up the majority of your retirement savings, with today’s lower tax rates, it could make sense to steer more of your money into Roth accounts or properly structured and funded life insurance policies.
Financial advisers consistently caution savers about the dangers of stockpiling too much of their retirement money in tax-deferred investment plans. Do a quick online search of the term â€śticking tax time bomb,â€ť and youâ€™ll see that advice goes back at least a decade.
There are benefits to these popular investment accounts. The automatic payroll deductions are convenient, and workplace plans often come with some percentage of employer match. Those are pretty nice perks. Plus â€” and this can be a big plus â€” every dollar you contribute to your 401(k), 403(b), SEP IRA, etc., is one less dollar on which youâ€™ll have to pay income tax that year.
But, of course, a day of reckoning is coming. When you retire, youâ€™ll pay taxes on every dollar you withdraw from those accounts. If your tax-deferred savings are a large part of your retirement income plan, the tax bill that awaits you could be substantial.
And yet, convincing investors that paying a little more in taxes today will save them down the road is a tough sell. Changing their ways will take some effort on their part, not to mention some money upfront, they tell us, so they want an incentive.
The tax reforms passed in 2017 could provide that push.
The Tax Cuts and Jobs Act puts many people into a lower tax bracket starting this year and for at least the next few years. That means wise savers have an opportunity to move a little or a lot of their pretax dollars to a Roth account or a life insurance policy with potentially tax-free withdrawals, pay the taxes now, and avoid what could be much higher rates in the future. Unlike with 401(k)s and traditional IRAs, with a Roth IRA, you never pay taxes on your qualified withdrawals, and your money grows tax-free as well.
Life insurance policies, when properly structured and funded, can work similar to a Roth and are not qualified â€” meaning contribution amounts can be much higher. In addition, life insurance can create income tax-free death benefits for your spouse or beneficiaries, as well as tax-free withdrawals (typically via policy loans) for long-term care or other retirement needs.
With the use of these tools, todayâ€™s relatively low tax brackets can help greatly reduce, and could possibly eliminate, future income tax payments and the effects of future tax bracket increases.
I know, conventional wisdom is that everyoneâ€™s taxes are lower in retirement. Weâ€™ve all been told weâ€™ll need less money and, therefore, require less income. But there are all kinds of problems with that theory. Unless youâ€™re planning to completely downsize your lifestyle â€” not just your home, but your car, your hobbies, your wardrobe, your meals, etc. â€” your expenses wonâ€™t necessarily be reduced.
Many people hope to stay active and actually do more in retirement, at least in the early years. In fact, I find that most retirees travel more in the first five to 15 years of retirement than any other time in their lives. When you do slow down a bit, there often are health care costs. And some big money-saving tax deductions go away when you pay off your house or lose a spouse.
Beyond all that, though, thereâ€™s the very real threat that tax rates could go up significantly in the future. Just as with the recent reduction in tax rates, you can expect politics to play a role in any increase. Hereâ€™s why:
We all complain about taxes now, but imagine what it could be like in the future if the government finally decides to play catch-up on its debts and obligations.
The current top rate is 37% for those whose taxable income is over $500,000 (individuals) or $600,000 (married filing jointly). For the middle two brackets, the current rates are 22% and 24%. Historically, rates have been much higher. In 1944, the top federal rate peaked at 94%. And in the â€™50s, â€™60s and â€™70s, the top rate remained high, never dropping below 70%.
If that isnâ€™t incentive enough to reposition a portion of your nest egg ASAP, Iâ€™m not sure what is. Alternatively, consider:
You can wait until 2025, when the new tax rates are set to expire. (Although, if thereâ€™s a change in administration, that window could grow smaller.) Or you could make things a bit easier on your pocketbook and convert a little each year for the next few years. But now is the time to talk to your financial adviser and tax accountant about what converting tax-deferred dollars to after-tax dollars could mean to you.
Find out if it makes sense to start defusing your potential â€śtax time bomb.â€ť
Kim Franke-Folstad contributed to this article.
It’s important to remember that most life insurance policies are subject to medical underwriting, and in some cases, financial underwriting, and the costs of a life insurance policy is dependent on your age and health at the time of application. Life insurance products contain fees, such as mortality and expense charges, and may contain restrictions, such as surrender charges. If properly structured, proceeds from life insurance are generally income tax-free.
Policy loans and withdrawals will reduce available cash values and death benefits and may cause the policy to lapse, or affect guarantees against lapse. Additional premium payments may be required to keep the policy in force. In the event of a lapse, outstanding policy loans in excess of unrecovered cost basis will be subject to ordinary income tax. Tax laws are subject to change and you should consult a tax professional.
Neither the firm nor its agents or representatives may give tax or legal advice. Individuals should consult with a qualified professional for guidance before making any purchasing decisions. Investment advisory services offered through Blue Ridge Wealth Planners, a Registered Investment Advisor. Securities offered through Madison Avenue Securities, LLC (MAS), member FINRA/SIPC. MAS and Blue Ridge Wealth Planners are not affiliated companies.
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