Retirement Tax Strategies for the Affluent Using Cash Value Life Insurance to Help Design a Secure Future Retirement Tax Strategies for the Affluent Page 1 17-76A
In this Guide 1. Introduction 2. Discover Overlooked Assets Which Receive Favorable Tax Treatment a. The Three Distinct Asset Categories b. How to Help Supplement Your Existing Retirement Funds 3. How These Assets Supplement Wealth-Building Strategies and Minimize Tax Risk a. Compare Your Options b. Diversify to Help Reduce Tax Risk 4. Take Control of a more Flexible Future 1 Introduction Social media and the online news sites love to publish articles discussing Americans reluctance to plan for their retirement. These articles paint a gloomy picture of a future with too little money saved, the possibility of reduced Social Security benefits, and many people feeling they may never be able to retire. While this may be the case for typical Americans, the affluent could have options that might not be appropriate for most people. You re likely already paying more in taxes, with a higher marginal tax rate than most. Strategies that reduce your taxes now and during retirement can make the difference between a reduction in your standard of living and financial security. This guide introduces strategies to get you thinking in the right direction and discusses steps you can take to keep more of your money. Retirement Tax Strategies for the Affluent Page 2
2 Discover Overlooked Assets Which Receive Favorable Tax Treatment The Three Distinct Asset Categories If you re like most high-income individuals, you re probably already maximizing your contributions to the first category of retirement assets, those held inside retirement plans, which includes qualified plans such as 401(k)s and traditional IRAs. But those plans have limits on how much you can contribute, and those limits aren t designed for people who are making a lot of money. So even if you fully fund them, you still may not have enough invested to afford the retirement you dream of, and you also risk outliving your retirement assets. Plus, the proceeds of traditional plans are generally taxed at income tax rates when you receive the distribution. Many people assume they will be in a lower tax bracket when they retire, but if you want to maintain your current standard of living that may not be the case. The taxes you pay in retirement can eat up a substantial portion of your savings. Your retirement portfolio may also include the second category of retirement assets: those held outside of retirement plans, which includes stocks, mutual funds, and real estate. These assets can provide substantial retirement income, but proceeds are generally taxed at capital gains or ordinary income tax rates. Other commonly-held assets like CDs are also taxable. The third category of retirement assets, often overlooked, can receive favorable tax treatment. This category includes Roth IRAs, which can have tax-free distributions; municipal bonds, which can pay tax-free interest; and cash value life insurance, which provides tax-deferred growth, tax-free 1 distributions, and death benefits. While Roth IRAs are useful, many wealthy investors earn too much to take advantage of their favorable tax treatment, and the amount you can contribute is limited. In a low interest rate environment, municipal bonds may not generate the kind of return you desire. ASSETS HELD INSIDE RETIREMENT PLANS ASSETS HELD OUTSIDE RETIREMENT PLANS OVERLOOKED ASSETS Distributions generally taxed Distributions generally taxed at capital gains rates Distributions generally tax free 1 For federal income tax purposes, tax-free income assumes, among other things: (1) withdrawals do not exceed tax basis (generally, premiums paid less prior withdrawals); (2) policy remains in force until death; (3) withdrawals taken during the first 15 policy years do not occur at the time of, or during the two years prior to, any reduction in benefits; and (4) the policy does not become a modified endowment contract. See IRC Secs 72, 7702(f)(7)(B), 7702A. Any policy withdrawals, loans and loan interest will reduce policy values and may reduce benefits. How to Help Supplement Your Existing Retirement Funds Many people don t realize that cash value life insurance, in addition to paying your policy beneficiaries a tax-free benefit when you die, can also be used to provide many important benefits while you are alive. These benefits can help supplement the income you receive from traditional retirement accounts, such as 401(k)s and IRAs. You have the flexibility to choose different products which allow options for how the premium can be allocated, and the cash value accumulates tax-deferred. This means that as your money grows, you pay no taxes on the gains. The tax savings continue when you want to take the money out. At retirement, you can take loans or distributions from the policy which are generally tax-free. Further, your distributions don t contribute to the income thresholds that trigger taxation of Social Security benefits. This favorable tax treatment is hard to find in any other asset type. Retirement Tax Strategies for the Affluent Page 3
3 How These Assets Supplement Wealth-Building Strategies and Minimize Tax Risk Compare Your Options By now, you may be wondering how to incorporate assets which receive favorable tax treatment into your retirement planning. This chart compares various asset types to show how they each contribute to your portfolio. UNLIMITED ANNUAL CONTRIBUTIONS PRE-TAX CONTRIBUTIONS TAX-DEFERRED ACCUMULATION TAX-PREFERRED DISTRIBUTION INCOME TAX-FREE DISTRIBUTIONS AT DEATH Traditional IRA2 3 Roth IRA 4 Qualified Plan CD5 Mutual Fund6 Municipal Bond Fund7 Individual Owned Deferred Annuity Cash Value Life Insurance 9 8 10 11 Individual Retirement Account A Roth IRA allows you to make contributions with after-tax money without current income tax deductions. You pay now and may enjoy tax-free income later, provided you hold the Roth IRA for at least five years and don t take distributions before reaching age 59 ½. If you do not meet the five years and attaining age 59 ½ requirements and need to take a distribution, you may owe income tax on earnings, and a 10% federal tax penalty may apply to the earning and prior converted amounts. Similar to the traditional IRA, there are exceptions to the 10% federal tax penalty for withdrawals and the age 59 ½ age requirement, such as first-time home purchase, death, disability, certain qualifying medical expenses, health insurance premiums, or higher-education expenses. 4 A distribution from a Roth IRA generally is income tax free if (a) it meets all the requirements for a qualified distribution (which include a 5-year waiting period and one of several additional requirements, one being that the distribution is made to a beneficiary on or after the death of the individual), or (b) it is a nonqualified distribution to the extent of after-tax contributions (basis). 5 Certificate of Deposit 6 Mutual finds may be subject to income tax and/or capital gains taxation. Consult your tax advisor for more information. 7 Generally, interest paid on municipal bonds is tax-free, but not all municipal bonds are exempt from federal and/or state income tax. Some bonds may be subject to capital gains tax at sale. Consult your tax advisor for more information. 8 There is not a specific limit on dollars allocated to purchase life insurance; however, there are maximum premium limits determined by a specified policy face amount. A policy will qualify as life insurance if it meets the requirements of IRC Sec. 7702, which includes limits on the amount of premium that may be paid into a specific face amount and still qualify as life insurance. 9 Upon Distribution, when a contract annuitizes, a portion of principal is included in the annuity payout. The principal portion is not subject to tax. 10 Tax-free income assumes, among other things (1) withdrawals do not exceed tax basis (generally, premium paid less prior withdrawals); (2) policy remains in force until death; (3) withdrawals taken during the first 15 policy years do not occur at the time of, or during the two years prior to, any reduction in benefits; and (4) the policy does not become a modified endowment contract. See IRC Secs. 72, 7702(f)(7)(B), 7702A. Any policy withdrawals, loans and loan interest will reduce policy values and may reduce benefits. 11 For federal income tax purpose life insurance death benefits generally pay income tax-free to beneficiaries pursuant to IRC sec. 101(a) (1). In certain situations, however, life insurance death benefits may be partially or wholly taxable. Situations include but are not limited to: the transfer of a life insurance policy for valuable consideration unless the transfer qualifies for an exception under IRC Sec. 101(a)(2) (i.e., the transfer-for-value rule ), arrangements that lack an insurable interest based on state law, and an employer-owned policy unless the policy qualifies for an exception under IRC Sec. 101(i). 2 3 Cash value life insurance is an important addition for wealthy individuals who have already contributed the maximum amount to other retirement accounts, or who don t qualify for certain types of accounts (like Roth IRAs) because their income is too high. Retirement Tax Strategies for the Affluent Page 4
Diversify to Help Reduce Tax Risk As the baby boom generation retires, overall income tax receipts are likely to decrease. How will the government make up the shortfall to fund programs like Social Security? While we don t know for sure, it s entirely possible that the tax code may be changed in response to changing demographic realities. This could mean that tax rates may increase, assets which currently provide tax-deferred growth may be limited, or entitlement benefits may be reduced. These potential changes contribute to tax risk. Because we can t predict the future, it s best to include in your planning a variety of different asset types, with different tax treatments, from the three distinct asset categories. By diversifying in this way, you may be able to reduce the negative consequences of a possible change to the tax code on your overall portfolio. 4 Take Control of a More Flexible Future We ve discussed how 401(k)s and other qualified plans have contribution limitations that are fine for most people, but don t allow high-income-earners the ability to save enough so they can continue their affluent lifestyle in retirement. Let s look at an example that shows how these limits can negatively impact you. Let s say that you are [ 45 ] and started saving for retirement at age [ 35 ] by contributing $10,000 [ ] per year to your 401(k). You are now fully funding your 401(k) with the maximum contribution of $18,000. [ ] Let s assume that 401(k) contribution limits are adjusted upwards each year by [ 1%, ] and that you start fully funding the catch-up amount, also adjusted upwards by [ 1% ] each year, at age [ 50. ] Let s say that your investment returns in the account are [ 6%, ] compounded annually. After [ 30 ] years, at age [ 65, ] you would have contributed over [ $600,000 and ] your account would be worth about [ $1.4 ] million. Medical science is increasing our lifespans, so let s assume that you live for [ 30 ] years in retirement. $1.4 [ million ] would allow you to withdraw a little over [ $46,800 ] per year from your 401(k). You are likely earning much more than that now, and will be earning even more by the time you retire. Plus, that amount is fully taxable upon withdrawal at your regular tax rate, which means you might only have an after-tax retirement income stream from your 401(k) of about [ $30,000 12 ]. Is this enough to fund the retirement lifestyle you dream of? For some affluent individuals, the answer may be no. Of course, you might have other sources of retirement income like savings, Social Security, stocks, and real estate, but earnings from those vehicles are also fully taxable. We ve learned that Roth IRAs are tax advantaged, but most affluent individuals can t participate due to the income limits. If you want to keep more of your money for retirement, you should review all of the available options. Cash value life insurance can also provide the flexibility to fund the policy based on your financial planning needs and access distributions before you retire. So, if you have financial obligations before age [ 59½ ](the age you must be to withdraw from traditional retirement plans without penalty), you have the opportunity to access policy distributions. Or, you can leave the money for potential future accumulation there is no forced distribution at age [ 70½ ] as in qualified plans to use when you see fit or leave to your designated beneficiaries. This is in addition to the safeguard for your loved ones who you have designated as beneficiaries provided by the tax-free death benefit. In conclusion, cash value life insurance isn t something that most people talk about, but for many affluent individuals, it can be overlooked as one of the best ways to help supplement traditional retirement plans. It can help you have the tax advantages and flexibility you want as you create a comprehensive plan for your family s future. 12 Assumes a 35% tax rate. Retirement Tax Strategies for the Affluent Page 5
Pacific Life refers to Pacific Life Insurance Company and its affiliates, including Pacific Life & Annuity Company. Insurance products are issued by Pacific Life Insurance Company in all states except New York and in New York by Pacific Life & Annuity Company. Product availability and features may vary by state. Each insurance company is solely responsible for the financial obligations accruing under the products it issues. Insurance products and their guarantees, including optional benefits and any crediting rates, are backed by the financial strength and claims-paying ability of the issuing insurance company. Look to the strength of the life insurance company with regard to such guarantees as these guarantees are not backed by the broker-dealer, insurance agency or their affiliates from which products are purchased. Neither these entities nor their representatives make any representation or assurance regarding the claims-paying ability of the life insurance company. Pacific Life s Home Office is located in Newport Beach, CA. This material is not intended to be used, nor can it be used by any taxpayer, for the purpose of avoiding U.S. federal, state or local tax penalties. This material is written to support the promotion or marketing of the transaction(s) or matter(s) addressed by this material. Pacific Life, its affiliates, their distributors, respective representatives and life insurance producers do not provide tax, accounting or legal advice. Any taxpayer should seek advice based on the taxpayer s particular circumstances from an independent tax advisor or attorney. Pacific Life is a product provider. It is not a fiduciary and therefore does not give advice or make recommendations regarding insurance or investment products. Life insurance is subject to underwriting and approval of the application and will incur monthly policy charges. 17-76A 17-76A Retirement Tax Strategies for the Affluent Page 6