The Tax Columns—How Will Taxes Affect My Retirement? Part 3Submitted by Axios Capital Strategies on December 4th, 2020
In part 1, we discussed the pros and cons of The Taxable Column. In part 2, a lengthy discussion was had for the same regarding The Tax-deferred Column. Finally, we come to the third category of financial vehicles called The Tax-free/Tax-advantaged Column. There should be no surprise that this is our favorite column to prepare for retirement with.
In our opinion, when it comes to retirement planning (or any kind of financial strategy) the first step is to minimize costs or fees. This allows you to keep more of what you are already earning. Many times, advisors try to earn more return (i.e., take more risk) in order to give a client more money/income or make the existing money last longer. Before increasing risk, why not decrease fees?
What is the largest fee related to retirement? Taxes. By far. After doing proper retirement planning, which includes mitigating taxes on your retirement to the greatest extent possible, you might find your current levels of returns are satisfactory and that you don’t need to take more risk just to overcome the tax bite. You may even discover that you can take less risk now that taxes are much less a burden (if at all), minimizing the severity of inevitable future economic downturns on your retirement portfolio.
The Tax-free Column
In this column, we find vehicles such as:
Life Insurance Retirement Plan (LIRP)
It’s easier with the Tax-free Column to start with the disadvantages. Each of these vehicles is funded with after-tax deposits. So, the pre-tax funding that is possible with qualified retirement plans (401Ks, etc.) is not possible here (with some complicated exceptions that exist for
certain business owners). You will recall how pre-tax savings are not all they’re cracked up to be from our discussion in part 2, but we’ll list after-tax deposits as a disadvantage (for now).
In regard to the Roth IRA/Roth 401K, you still have the age restriction disadvantage that a regular IRA/401K has. Unless you’re 59 ½ years old, you’re not going to be able to access your gains from these accounts without paying taxes and penalties. But, did you catch that? The gains. Your principle, the amount you put into a Roth, you can take out at any age. So, the taxes and penalties prior to age 59 ½ do not apply to your principle, just the gains. Cool, right?
The Roth IRA has low contribution limits as well. Depending on your age, you can only put in $6,000-7,000 per year. If you’re married, your spouse can also have one and you can double it up. However, because of the lower contribution limits the Roth IRA will always likely be supplementary in your retirement planning, not a foundational piece (unfortunately). Depending on how much money you make, your ability to contribute to a Roth IRA can be limited or phased out completely. Thankfully, those income limitations do not apply to the Roth 401K.
Municipal bonds are a quasi-member of the Tax-free Column. While the interest they produce is federally tax-free and might be state income tax-free (depending on what state you live in and which muni-bonds you buy), the interest counts as Provisional Income (PI), just like 401K, pension, IRA distributions, interest on CDs and bank accounts, rental income, and capital gains from stocks/mutual funds/ETFs. PI determines whether or not your social security income will become unnecessarily taxable. So, these so-called tax-free bonds might cause your social security to be taxable, or taxable to a greater extent. Ugh.
Further, when you sell a muni-bond for a gain, you create a capital gain (long or short-term) and will owe taxes on that. Those capital gains are also Provisional Income. So, you can see why this vehicle has one foot in the Tax-free column, and another foot and two hands in the Taxable Column.
The Life Insurance Retirement Plan (LIRP) is a maximum-funded tax-advantaged insurance contract that is capable of producing tax-free distributions to you if set up right. Its specific drawback is that you have to be decently healthy to make this viable due to the insurance qualification requirements. Now, you do not have to be in “superman health,” and many normal conditions that develop with aging are acceptable; but if you have had multiple series health encounters, this instrument may not suffice for you.
Excepting the municipal bonds (which we considered striking from this column altogether), each of these vehicles accumulate and distribute gains without taxes hindering them when used properly. This advantage cannot be overstated. We don’t really think any other advantage need apply. The implications and ripple effects are far-reaching. The first major advantage of this column is to be able to structure multiple streams of tax-free income.
The Roth IRA, Roth 401K, and Life Insurance Retirement Plan give you distributions for retirement that do not count as Provisional Income thereby not causing your social security income to become unnecessarily taxable. These are the only three retirement vehicles that have this characteristic, and it is a significant one. Instead of having 50% or 85% of your SSI taxable at your highest marginal tax bracket, properly utilizing any or a combination of these three vehicles has the ability to leave your SSI tax-free, the way it is supposed to be (in our humble opinion). Remember, SSI on its own is not a taxable source of income. The other types of vehicles you use for retirement planning determine whether or not it stays that way. The Tax-free Column goes a long way toward achieving that goal.
Another advantage already mention in the “Cons” section above is that ability to access your principle (cost basis) under 59 ½ without taxes (because, yes, that money has already been taxed as these vehicles are funded with after-tax proceeds). This applies to each of the vehicles listed. Liquidity, therefore, is greatly increased.
A significant advantage of the LIRP, however, is that provisions exist in these contracts to allow you tax-free and penalty free access prior to age 59 ½ of even your gains. Therefore, a properly structured LIRP can completely wipe away the age restriction disadvantage of the Tax-deferred Column. This can give great liquidity potentially for opportunities and emergencies that might come up. LlRPs also contain a tax-free term insurance death benefit for your heirs (because none of us are getting out of here alive), and often a long-term care provision to allow you to use the death benefit for long-term care costs above and beyond the account value.
Next, there are no RMDs. Remember how the IRS forces you take a certain amount out of your 401K/IRA (and their siblings) in the year you turn 72 even if you don’t need to use the money in order to force you to pay some takes? That doesn’t apply to this column because, well, the IRS doesn’t care if you ever use this money because they aren’t involved anymore. They no longer get a cut of your pie.
A Common Misperception
A common misperception (and question) that people often have is that Roth IRAs, Roth 401Ks, and LIRPs are only "tax-free" because you’ve already paid the taxes upfront (used after-tax proceeds to fund the account). This is partially true but reveals a misunderstanding of what is meant by "tax-free" regarding these vehicles. The question is not whether you will pay taxes on your contributions to a retirement account. You will. Upfront (when you know what your tax bracket is and likely have deductions to help), or on the backside (when taxes are likely to be higher and fewer if any deductions exist outside the standard deduction).
So, settle that in your mind. You will pay taxes on your contributions. That’s not the question. The question is whether or not you will pay taxes on your gains. Your earnings or growth. That is the key question.
In the Tax-deferred Column, you will pay taxes on both your contributions and gains in the future (likely higher tax-bracket and/or fewer deductions, no long-term capital gains rates, etc.). In this Tax-free Column, you will only pay taxes on your contributions (after-tax funding) and not on the gains (so long as you follow a few simple rules). Over time, your gains should make up the vast majority of your account value (or that’s the hope!). That is what "tax-free" refers to: your gains being truly, completely tax-free.
Pre-tax vs. After-tax
Let’s tackle this pre-tax vs. after-tax concept once and for aII. We’ve discussed the "pre-tax penalty" in part 2 (loss of the lower long-term capital gains treatment). We’ve also laid out how after-tax funding is seen as a disadvantage for this column. Just as the "advantage" of pre-tax funding ends up having a very high cost, the "disadvantage" of after-tax funding comes with a bonus.
Essentially, the IRS has a deal for you. If you accept their offer to fund retirement with pre-tax dollars, they will let you do that in exchange for paying taxes later at likely higher rates and a complete loss of preferential long-term capital gains treatment during your retirement (the Tax-deferred Column). However, if you use after-tax dollars to fund retirement, meaning the IRS gets some money now instead of, say, 30 years down the road, they reciprocate with that favorably. In retirement, instead of having to pay taxes at ordinary income rates on your gains, or even the lower long-term rates, they allow you to have completely tax-free gains (the Tax-free Column). Further, as already mentioned, when you take distributions from the vehicles in this column (with the exception of muni-bonds), they do not count as Provisional Income. So, not only will your distributions from a Roth or LIRP be tax-free, but they will not cause your social security income to be eroded by unnecessary taxes.
That is what we call the after-tax bonus, and it is huge.
Now, what if taxes double in the future, as many experts, economists, accountants, and politicians (on both sides) are on record as believing is a real possibility (have you seen our national debt recently? Twenty-seven trillion. Ugh...)?
If you’ve relied heavily on the Tax-free Column for your retirement planning, you don’t care.
What if they eliminate a bunch of tax deductions, and/or let the standard deduction get cut in half (which is scheduled to happen January 1, 2026)?
You don’t care. lt won’t affect you.
However, if you’ve heavily used the Tax-Deferred and/or Taxable Columns, you care. You really care. You will be severely affected and could find your golden years turning rather blue. No one wants this.
Control What You Can Control
We believe it critical to control what you can control. It’s difficult to control what congress does or does not do with regard to taxes and tax-deductions in the future. But, it is not difficult to control whether or not you subject your retirement dollars to the changing tax landscape. All three Tax Columns have a place and proper use. Not one of them is perfect, and the right blend between the three in your situation can likely yield a much more confident retirement outlook for you, including making your retirement potentially completely tax-free.
lt takes time.
lt takes proper planning. lt takes some calculations.
It takes some flexibility and willingness to take the road less traveled.
lt is worth it.