Current thinking in the United States is that taxes are more likely to go up than down in the future. The fiscal policy in Washington is such that it is almost a certainty that either taxes will go up or we will face a financial meltdown. Regardless of your political view you are aware that some day you will pay income taxes on all the money in your various retirement accounts. Everyone only has two buckets of money: money they have paid taxes on and money that have not paid taxes on. One problem with putting too much money into to tax deferred accounts is that is raises your exposure to future tax increases. Due to company matches and the lure of immediate tax deductions, 401k’s are very popular. One hedge against higher taxes is having a bucket full of tax free cash.
Tax free cash may take the form of personal investments, money in the bank, home equity, or Roth IRA’s. Each has advantages and disadvantages. You can delay taking money from an IRA to live on in retirement by taking out a home equity loan – tax free. Some people may cringe at the idea of having a paid off house and using it to live on. However taking the same amount out of an IRA at a 35% tax rate doesn’t sound appealing either. What if you could accumulate a bucket of tax free cash for retirement that you could take when you wanted without any complex IRS rules? In addition, what if this basket had no exposure to market volatility? Besides income taxes, all investors still must battle inflation and market risk as well.
The solution I call the “Unlimited Roth” is actually permanent life insurance. Although there are many types of permanent life insurance, they all share several characteristics: Tax free access to cash, a permanent death benefit, no limits to how much money you can invest and the complete absence of stock market volatility. Most people are familiar with term insurance which, in exchange for a premium, a life insurance company guarantees your family a definite sum of money at an indefinite time in the future. Unfortunately term insurance will run out eventually, or become too expensive to maintain and all the premiums are lost if you live.
There are many pundits who say “buy term and invest the difference”. This only works if you know with 99% certainty precisely how long you will need the insurance and can earn 7% r 8% every year on the difference without market risk – an obvious impossibility. In my view, the best type of permanent insurance is whole life issued by a mutual insurance company. A mutual insurance company has no stockholders, only policy holders. Therefore any profits are returned to the policy holders through dividends. To illustrate this concept we will use a hypothetical client, age 41, in good health and a real insurance company. This hypothetical example was produced on November 5, 2010 and is subject to change.
In our example, the client pays $9513 for 20 years from age 41 to 61 for a total of $187,276. This premium buys an initial death benefit of $250,000 but grows to $711,640 at the end f the 21st year. Assuming the client has enough assets to protect his family, he no would not longer need the death benefit, at least not for income replacement. Therefore the policy changes purpose from protection to income generation. The client could pull out $11,000/yr tax free for the rest of his life. If he lived to be 100, he would have pulled out $269,390 more than he paid in and his family would still receive $689,947 at his death – all tax free!
This scenario is based on the current dividend scale and dividends are NOT guaranteed. However this particular company has paid dividends in 150 out of 150 years of its existence. This included WWI, WWII, the Great Depression, Viet Nam, 911, all the market crashes and all the other turmoil we’ve seen in the last 150 years. In addition the cash value in the policy is available during the 2o year pay in period, not just at the end so it also acts as an emergency fund or college funding tool. A true financial professional will sit down with you and custom design a solution based on your circumstances and an entire array of products.
What is a “paid up addition”?
One reason whole life works as well as it does is a feature called paid up additions. These are small policies you buy with cash or dividends which are paid up – meaning there will never again be any expenses associated with that tiny policy. Over time they are stacked on top of each other and continue to produce dividends and interest.
If you would like more information on creating a tax free retirement, contact us by phone at 512.535.2674
Copyright © 2010 David H. Disraeli, President The Personal CFO
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