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Life Insurance as an Alternative to a Non-deductible IRA – Reason #2: Diversifying Taxes on Retirement Income

The coming tax season is a perfect time to help your high-income clients assess the options available for their additional savings.

In a series of 6 back-to-back blogs we illustrate 5 key reasons why cash value life insurance can be a powerful savings vehicle when compared to other retirement income sources, especially a non-deductible IRA:

  1. Replacing the Post-Retirement Income Gap
  2. Diversifying Taxes at Retirement
  3. Cushioning a Market Downturn
  4. Guarding Longevity
  5. Maximizing Social Security

Today we flesh out Reason #2

REASON #2 DIVERSIFYING TAXES ON RETIREMENT INCOME

A concern for many retirees is how to ‘reduce and time’ income tax liability. When planning for retirement, clients with higher incomes must decide in which additional retirement vehicles to put their additional savings once they reach their qualified plan limits ($19,000 in 2019 plus a $6,000 catch-up for clients age 50 or older). Or, in the case of a traditional IRA, the maximum contribution to an IRA is $6,000 in 2019, plus a $1,000 catch-up for clients age 50 or older.   Diversifying the income tax treatment of investments can reduce income taxes in retirement. Take a look:

 

How Life Insurance can help diversify taxes at retirement. Let’s assume that Terry retires and plans to withdraw $120,000 from her 401(k) annually. At her 35% tax bracket she would be left with $78,000. Alternatively, she could take a combination of withdrawals from various retirement income sources with different tax consequences and increase her net annual income by $22,000 to $100,000. Take a look:

NON-DIVERSIFIED WITHDRAWALS DIVERSIFIED WITHDRAWALS
Mutual Fund Withdrawals Cash value life insurance 401(k) Plan Total Net Income from all sources Mutual Fund Withdrawals Cash value life insurance 401(k) Plan Total Net Income from all sources
Withdrawal $120,000 $40,000 $40,000 $40,000
Tax $42,0001 $6,0002 $0 $14,0003
Net Income $78,000 $78,000 $34,000 $40,000 $26,000 $100,000
1 Ordinary Income Tax @ 35%.
2 Capital Gain Tax at 20%
3 Ordinary Income Tax @35%
GENERAL COMPARISON OF RETIREMENT INCOME SOURCES
Taxable
Investments
Qualified Plans/
Traditional IRA
ROTH
IRA
Non-
Deductible
IRA
Cash Value
Life Insurance
Non- Qualified
Deferred Annuity
Muni
Bonds
Deductible
Contributions
No No No No No No
Tax-Favored
Withdrawals
No No No
No Mandatory
Withdrawals
Mandatory
distributions
Mandatory
distributions
Tax- Deferred
Growth
No
Income Tax-
Free Death
Benefit
No No No No No No
No Tax Penalties
for Early
Withdrawals
Early withdrawal penalty Early withdrawal penalty Early withdrawal penalty Early withdrawal
penalty may apply
No Contribution Limits Contribution limits Contribution limits Contribution limits
Cost of Insurance Charges No No No No No
Market Risk Depends on product
Long-Term Care Coverage No No No No No
Non- Reportable Income No No No No No No

The moral of the story here is to ensure that high-income earners diversify their tax situation in retirement by contributing to a number of savings vehicles that will not only help their income tax situation today, but also at retirement.

Like a non-deductible IRA, life insurance is funded with after-tax contributions and offers tax-favored distributions. However, unlike the non-deductible IRA, life insurance offers death benefit protection during the working years, access to the death benefit during lifetime to cover long-term care expenses (when a rider is attached) and has no contribution limits. In addition, the policy may be protected from the claims of creditors and the distributions from the life insurance are non-reportable. These features can be very appealing to many, especially physicians, attorneys and personal service companies.


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In case you missed it…
Life Insurance as an Alternative to a Non-deductible IRA? 5 Reasons Why – Intro
Reason #1: Replacing the Post Retirement Income Gap

Stay tuned for our next blog post…
5 Reasons Why: Life Insurance as an IRA Alternative
Reason #3:  Cushioning a Market Downturn

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