A: Allow me to answer this question with a few questions of my own. What if you decide not to take advantage of today’s historically low tax rates and postpone the payment of those taxes until a later date? What if at that later date, tax rates are twice as high as they are today? Will you look back at this period of historically low tax rates and say, “Why didn’t I take advantage of those rates while they were on sale?” So the real question that you have to consider is this: Do you think you’ll still be alive when tax rates are higher than they are today? If so, you’re not too old to take advantage of these strategies.
Q: Can I be in the 0% tax bracket and still be a good citizen?
A: Let me answer this by deferring to Judge Learned Hand, the most famous judge that never became a Supreme Court Justice:
“Any one may so arrange his affairs that his taxes shall be as low as possible; he is not bound to choose that pattern which best pays the Treasury; there is not even a patriotic duty to increase one’s taxes.”*1
“Over and over again the courts have said that there is nothing sinister in so arranging one’s affairs as to keep taxes as low as possible. Everybody does so, rich or poor; and all do right, for nobody owes any public duty to pay more than the law demands.”*2
I would like to emphasize one additional point. We’re not suggesting that you not pay taxes. The cost of getting into the tax-free bucket is that you have to be willing to pay taxes today. We’re simply suggesting that you pay taxes at historically low tax rates to avoid potentially higher rates later on.
Q: If this is so great, why isn’t everyone doing it?
A: I’ve found that many advisors who adhere to the traditional tax-deferred approach to retirement planning can be averse to this type of planning. Here’s why: The typical financial planner makes a living by managing your money. A typical fee might be 1% of your assets per year. If a financial advisor is managing your $1,000,000 IRA, then he’s making about $10,000 per year. If he convinces you that taxes in the future are going to be substantially higher than today, you might feel compelled to shift that $1,000,000 into the tax-free bucket. The problem is, the tax-free bucket has a cost of admission: taxes. Let’s say that you pay 30% in taxes to get into the tax-free bucket. Your advisor is now only managing $700,000 of your money. If he’s still making 1% of your total assets, he just cut his pay from $10,000 to $7,000. Most financial advisors get paid to make your money grow, not to maximize your distributions in retirement. It is important that your money grow in retirement, but it’s critical that it grow in the right environment. Remember, not all buckets are created equal.
Questions about the Taxable Bucket
Q: What happens if I receive an inheritance?
A: One of the most important questions that we can ask in the planning process is the timing and amount of inheritances. You see, most inheritances come to you in the form of a check, which you promptly deposit into your checking account (i.e., the taxable bucket). You could have spent ten years shifting assets out of your taxable bucket into the tax-free bucket, only to see your prospects of getting to the 0% tax bracket dashed by this unexpected windfall. For that purpose, it’s important to try to guesstimate the timing and amounts of inheritance (as hard as that is to do) so that your Tax-Free Road Map can make provisions for that money to be shifted into the tax-free bucket.
Q: What if I want to have more than six months’ worth of income in my taxable bucket?
A: It’s acceptable to have more than six months’ worth of income in this bucket so long as you recognize that it comes at a price. Since a disproportionate percentage of your net worth is taxable, you could end up paying more taxes than is necessary and, ultimately, risk having a portion of your Social Security taxed.
Questions about the Tax-Deferred Bucket
Q: Is there ever an instance where I would not want to contribute to my 401(k) up to my employer’s match?
A: Actually there is. Remember, one of the main goals of your Tax-Free Road Map should be to make your Social Security tax-free, if possible. In some cases, making a contribution to your 401(k) just so that you can get an anemic match could ultimately cause your Social Security to be taxed.
For example, your 401(k) requires you to contribute 6% of your income in order to get a 25-cents-on-the-dollar match. You’re deferring a significant portion of your income to your 401(k) just so that you can capture this infinitesimally small match. As a result, you’re pumping up your 401(k) to the point where your RMDs may be so large that your Social Security becomes taxed. It might make more sense to forgo the match and divert that 6% to your tax-free bucket to increase the likelihood of getting your Social Security tax-free. Once again, a tax-free planning specialist can help you understand if your 401(k)’s match is big enough to justify making a contribution.
Questions about the Roth IRA
Q: Can the government decide to tax your Roth IRA at retirement?
A: Since 1997, the IRS has given you the option of being taxed on the “seed” or on the “harvest.” With a Roth IRA, you’re taxed on the seed; with a traditional IRA, you’re taxed on the harvest. To tax you on both the seed and the harvest would be unprecedented and would likely get more than a few politicians thrown out of office. A more likely scenario would be for the IRS to eliminate all future contributions to the Roth IRA. You’d likely keep what was in there, but lose the ability to make further contributions.
Q: What is the 5-year rule with the Roth IRA?
A: This rule determines whether or not distributions from your Roth IRA are taxable. First of all, all contributions can be taken from your Roth IRA at any time without tax and without penalty. In order to take the growth out of these accounts penalty-free, you have to be at least 59½ and have had an established Roth IRA account for at least five years. For example, let’s say that you’re 60 and you make a first-time contribution of $6,500 to a Roth IRA that grows to $7,000 by the time you’re 61. You could withdraw the $6,500 at any point, but would have to wait until five years after your initial contribution date to access the growth. The initial contribution date is January 1 of the tax year in which you made the contribution.
Q: If I’m working part-time in retirement, can I still contribute to a Roth IRA?
A: To contribute to a Roth IRA, you have to have earned income—you have to be earning a paycheck. For anyone over age 50, you can contribute whatever your earned income is or $6,500 (in 2018), whichever is less. If you and your spouse are over 50 and only one of you is working, you can contribute up to $13,000 or whatever your earned income is, whichever is less.
Questions about Roth Conversions
Q: What is the 5-year rule with the Roth conversion?
A: If you do a Roth conversion before you are 59½, you have to wait five years or until 59½, whichever comes first, before you can touch the principal without tax and penalty. If you’re already 59½ when you make the conversion, you can touch the principal immediately but have to wait five years before you touch any of the earnings without penalty.
Q: Does the Roth conversion have income limitations?
A: Prior to 2010, there was a $100,000 income limitation, but now anyone can do a Roth conversion regardless of income level.
Q: How quickly should I convert my Roth IRA?
A: Quickly enough that you pay the taxes owed before tax rates rise dramatically, but slowly enough that you don’t bump yourself into a dramatically higher tax bracket.
Q: Does it ever make sense to convert my IRA to a Roth all in one year?
A: The first scenario in which you might want to convert all of your IRA in one year is if it’s small enough to keep you in a reasonably low tax bracket. For example, if you make $100,000 per year and you have a $30,000 IRA, you could convert all of it while staying in the 22% tax bracket.
The second scenario in which it might make sense to convert all of your IRA to a Roth in o
ne year is if you anticipate always being in the highest marginal tax bracket. For example, if you’re currently in the highest marginal tax bracket (37% in 2018) and don’t see that changing in retirement, you could convert unlimited amounts of IRAs and only be taxed at 37%. This especially makes sense if you think the highest marginal tax rate in the future will rise over time. Take advantage of the low rates today and get all the shifting done in one year.
Questions about the LIRP
Q: What are the expenses in the LIRP?
A: Most LIRPs have some administrative expenses, but the majority of expenses come from the cost of insurance. These expenses are greater in the early years and lower in the later years. But, considered over the life of the program, they should end up costing you about 1.5% of your bucket per year, assuming the policy is structured to maximize cash accumulation. This is very similar to the expenses that you might find in a traditional 401(k). In the 401(k), you’re paying three different people or entities—the money manager, the financial advisor, and the third-party administrator. In the LIRP, you don’t pay these expenses, but you do pay the cost of insurance. The difference with the LIRP is that the 1.5% you pay per year over the life of the program actually gets you a real, substantive benefit, which you can then utilize during your lifetime for the purpose of long-term care, or at death as a death benefit.
Q: How soon can I touch my money?
A: LIRPs generally have a surrender period or vesting schedule, similar to a 401(k). These restrictions exist because life insurance companies incur substantial expenses when getting these programs up and running. By putting a surrender period in place, they’re simply saying that, should you decide to cash everything in and run for the border, they reserve the right to recuperate all those expenses they incurred at the outset of the program. In other words, they don’t want to take a bath if you have second thoughts three years into the program. In fact, most of these companies don’t manage to break even until seven years into the contract. Having said that, with most LIRPs, you do typically have limited access to the money in the first or second year.
Although it’s important to understand what escape hatches you have, you must also bear in mind that this bucket works the best when you allow it to grow and marinate over time. As a general rule, your tax-free vehicles are your most valuable and should be the last to be liquidated in the event of an emergency. Ideally, you want to postpone distributions from these assets until a period of much higher tax rates. Conversely, the best time to shift or spend dollars from tax-deferred assets is during periods of historically low tax rates. By following these rules, you will ultimately have math on your side and be able to wring the most efficiency out of your retirement dollars.
Q: What happens if I run out of money in my LIRP before I die?
A: We want to avoid this scenario at all costs. If you don’t have at least $1 in your LIRP at death, the government says that your intent wasn’t really to utilize this vehicle as a life insurance contract. So, all the taxes that you avoided along the way would come due all in one year. For that reason, your LIRP must have features that safeguard against this ever happening. Some companies call this provision an over-loan protection rider.
Q: How can distributions from a LIRP be tax-free?
A: Distributions are only tax-free if the money is taken out the correct way. If you take a normal distribution, like you might with a 401(k) or IRA, the money can be taxable. By taking money out by way of a loan, however, then it is tax-free. Anytime you receive a loan, whether from the bank or your rich uncle, that money does not show up on your tax return as income. Why? Because the IRS anticipates that you will pay the money back with dollars that have been taxed.
When you take money out of your LIRP, the life insurance company is actually giving you a loan from their own coffers. This is how it works: You call up and say, “I need $10,000.” They take $10,000 out of your growth account (with a balance of $100,000) and put it into a loan collateral account that earns 3% per year. Now you have $90,000 in your bucket, right? Wrong. Since you still have $10,000 in your loan collateral account, your bucket technically still contains $100,000.
In the very same transaction, the life insurance company sends you a loan from their own coffers. For this loan, they charge you 3% interest. Remember, loans don’t show up on your tax return. When you die, all the money in the loan collateral account is used to pay back the outstanding loan that you have with the company. Because the interest charged on the loan is the same as the interest being credited in the loan collateral account, the net cost to you over the course of your lifetime is zero. In short, you asked for $10,000, you received $10,000 in the mail, your growth account went down by $10,000, and you never paid any tax. That’s how we utilize this bucket to take tax-free distributions.
Q: How soon can I take the 0% loan?
A: It depends on the company, but, in some cases, it can be as early as the 1st day of the 6th year.
Q: What if I want to take money out before the 0% loan option is available?
A: As a rule of thumb, if you need to take money out before the 0% loan is available, you can simply take a withdrawal. Any dollars that you’ve contributed to the program (your basis) can be distributed tax-free as a return on your principal.
Q: What’s the difference between death benefit options in a LIRP?
A: You can structure your LIRP’s death benefit in two different ways, or “options.” With Option 1, as the cash in your account grows, the amount of life insurance that the government requires you to maintain goes down. It follows this formula:
Cash Value + Life Insurance = Death Benefit
Let’s say that in Day 1 of the program, your cash value is 0. Following the above formula, if your death benefit is $500,000, then the amount of life insurance you’re paying for that year is also $500,000. However, 10 years into the program, you might have closer to $100,000 in your growth account. Following that same formula, the amount of life insurance you would pay for that year would only be $400,000.
With Option 2, the amount of life insurance that you’re paying for never changes. Therefore, in the above example, if you had cash value of $100,000, then the amount of life insurance you’d be paying for in year 10 would still be $500,000, making your overall death benefit $600,000. For this reason, Option 2 is also referred to as an “Increasing Death Benefit” option.
Q: What limits do I have on how much money I can put into the LIRP?
A: The IRS links contribution levels in the LIRP to death benefit amounts. The greater the death benefit, the more you can contribute. But it’s the life insurance companies, not the IRS, that place limits on how much of a death benefit you can have. In the post-9/11 world, this death benefit amount tops out at about 25 times your annual salary, with slight modifications for age. Let’s say that you’re 45 and make $100,000 per year. Based on the parameters that I just mentioned, the life insurance company would typically allow a death benefit as high as $2,500,000. In this scenario, you would be allowed to contribute up to $170,000 per year! For all intents and purposes, there are no contribution limits to the LIRP, so long as your death benefit remains at 25 times your salary or less.
Q: What if I run across hard times and can’t fund my LIRP for a while?
A: So long as there is money in your surrender value to sustain the expenses that drip out of the spigot, you can stop your contributions.
Q: If I get a big bonus from work, can I just drop it into my LIRP?
A: You can, but it may inhibit you from putting more money in later down the road. Generally, based on the death benefit of your LIRP, there is a finite amount of money that you can contribute over your lifetime. The IRS also requires that you stream this money in over a period of years as opposed to contributing it all in a single year. If you put too much money in during any given year, you can violate the IRS guidelines and lose the tax-free protection of the buc
ket.
Q: Will the IRS ever change the rules on this program?
A: Most likely yes. As our country slides slowly into insolvency, they’ll start looking in all quarters for additional revenue. This program costs the government about $80 billion per year, so they will most likely attempt to eliminate it somewhere in the future. However, if history serves as a model, this program will likely enjoy significant protection from legislative risk. In 1982, 1984, and 1988, the government changed the rules on the LIRP and, when they did, they stipulated that the people who had these programs before the rules changed were allowed to keep them and could continue to contribute to them under the old rules for the rest of their lives. We call this a “grandfather clause.”
Q: Why does the IRS allow a 0% loan?
A: Technically, it’s not a 0% loan. You are actually taking a real loan from the life insurance company and being charged a real rate of interest in order to preserve what the IRS calls an “arm’s length transaction.” The IRS’s chief concern is that the life insurance companies charge a reasonable interest rate. They don’t care what the life insurance companies do with the loan collateral account on the other side of the ledger. Some life insurance companies credit back the same exact amount that’s being charged in order to make it both a tax-free and cost-free transaction.
Q: How does the long-term care rider work?
A: If you can find a doctor who will write a letter that says you can’t perform two of the six activities of daily living (e.g., feeding yourself, bathing yourself, etc.), then some companies will give you your death benefit in advance of your death. Put differently, they will give you your death benefit while you are still alive for the purpose of paying for long-term care. If your death benefit is $300,000, for example, certain companies will send you a check for as much as 2% of that amount, or $6,000 per month, every month for the next 48 months. Whatever portion of the death benefit that doesn’t get spent on long-term care will go to your heirs at death.
The Power of Zero, Revised and Updated Page 10
