There are essentially three buckets where you can place your retirement dollars: taxed now, taxed later or taxed never. When planning for retirement it is important to be proactive about the potential consequences your funds may receive tax-wise. Spreading out the tax risk is one strategy known as tax diversification.
There are over $3.5 trillion sitting in America’s 401K plans and another $2.5 in traditional IRAS. This represents the majority of America’s wealth outside the equity in their homes. In 1975 the Traditional IRA was born and a few years late the 401K. Both of these plans shifted the responsibility of planning for retirement away from the employer, who may have offered some type of pension plan, and placed it squarely on the individual participant. But typically there was no objective advisor to guide participants through the process of selecting funds, allocations, or a strategy. What many don’t realize is that the 401K and traditional IRA opened up tax deferral now in hopes of a lower bracket later at point of retirement. This idea of being in a lower tax bracket in the future is maybe looking more and more speculative when you see the history of income taxes in the past.
So if taxes actually end up higher in retirement than during contribution years, then traditional IRA or 401K may have little or no advantage whatsoever. Maybe the current lower tax environment will continue but with nearly 20 trillion in national debt and social security scheduled to run out in 2034 many are expecting taxes to rise. If that happens those with the majority of their funds held in 401Ks, IRAs, and 403bs could be feeling it.
The taxed now accounts include bank accounts and investment accounts. These can be important parts of retirement planning because funds, even though they are not tax-deferred, may receive a lower-tax than ordinary income. Long-term capital gains and qualified dividends are taxed at just 15%. In 2013 this was changed to 20% for high-income earners, but even at 20% it beats the otherwise much higher ordinary income tax.
There are only three products that can offer taxed never treatment; 529 college saving plans, ROTH IRAs and cash-value life insurance. All three of these use post-tax dollars to receive gains completely tax-free. Both 529s and Roth IRAs have contribution limitations and restrictions on who, when, and/or how the money can be used. The Roth IRA for instance has a contribution limit of $5,500 for an individual under 50 as of 2016. A 529 can only be used for college related expenses. Cash-value life insurance however is limitless as to how much is used to fund the contract provided the insured can show insurable interest (normally a multiplier of earned income). Plus there is no restriction on how the money is used. But to ensure tax-free treatment of cash in the policy it is important to carefully make sure that it is designated as a NON-MEC or non-modified endowment contract, that it remain in-force during the life of the insured, and that distributions are designated a loan. Also it is important that the owner and/or insured scrutinize the policy illustration, or projections of cash values, at point of application. Not all plans are equal and unfortunately some don’t not perform as illustrated. If you currently hold a cash-value life insurance contract it is important to review the performance on a regular basis. To talk to a professional about cash value life insurance or to review an existing contract click here.
So which bucket is right for you? Taxed later, taxed now, or taxed never? It could be a that all three place some part in a proper retirement plan, but understanding the tax risks is an important first step in helping mitigate a financial drag on building a nest egg.
** Fortier Insurance Serves offers insurance-related products and does not operate as a licensed tax advisor or certified financial planner.