Life Insurance

Tax Diversification

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Life Insurance & Tax Diversification

An old adage tells us that death and taxes are certainties. So how can these be addressed – especially for the long term? Putting in place valuable death benefit protection creates a core financial component when looking to your financial future and so is looking proactively at long term tax consequences.

Do you want to find ways to maintain your retirement savings and pay less in income taxes?

While today’s economic environment continues to offer challenges, there are some important strategies to consider as you build your nest egg.

The Importance of Tax Diversification for a Strategic Retirement

It is important to take income taxation into consideration as you plan for the future. If you’re like many today in the midst of planning for retirement, you probably have several different types of investment accounts.

These accounts tend to fall into three general categories as it pertains to how the values within them will ultimately be taxed.

These categories include taxable, tax-deferred (which includes two sub-categories), or tax favoured accounts.

Typical account types separated in categories

TAXABLE ACCOUNTS

(after-tax dollars with potential income taxes along the way):

Money Markets

CDs

Mutual Funds

Stocks

Bonds

Real Estate Rentals

TAX-FAVORED ACCOUNTS

(after-tax dollars with tax-free dollars out):

Muni Bonds (in most cases)

Roth IRAs

Mutual Funds

529 Plans

Cash Value Life Insurance (when structured properly)

TAX–D E F E R RED

(after-tax dollars in with taxable dollars on gains out):

Non-deductible Traditional IRAs

Non-qualified Annuities

(pre-tax dollars in with fully taxable dollars out):

Deductible Traditional IRAs

401(k) Plans

Qualified Annuities

Pension Plans

Defined Benefit Plans

Non-qualified Deferred Compensation Plans

As you approach your ultimate retirement date, where do you think income tax rates will be — especially since tax rates are at or near historical lows today?

That answer is hard to determine with certainty — however, it’s important to understand how these account types are taxed.

General summary of some of the tax considerations

ContributionsAccumulationDistributions
Certificate of DepositAfter-TaxTaxableNon-Taxable
Mutual FundAfter-TaxTaxableNon-Taxable
Muni Bond FundAfter-TaxNon-TaxableNon-Taxable
Employee 401(k)Pre-TaxTax-DeferredTaxable
IRAs – RegularPre-TaxTax-DeferredTaxable
Roth IRAsAfter-TaxTax-DeferredNon-Taxable
Permanent Life InsuranceAfter-TaxTax-DeferredNon-Taxable

So what is the impact on the benefits shown in the previous chart when your money is mixed among these different categories of accounts? Well, for one thing, having dollars spread among these various account options can give you some flexibility and choice when determining how much taxation you will incur during your retirement years.

Look at the following hypothetical example that shows what would happen if you take 100% of $100,000 out of a 401(k) account (after age 59½) versus taking 50% of the money out of a 401(k) and 50% out of a tax-favored asset , such as a Whole Life insurance policy.

100% 401(k) Withdrawal

401(k)
Money Withdrawn$100,000
Taxes Paid (28%)$28,000
Total Net Withdrawal Amount$72,000

50% 401(k), 50% Whole Life Cash Value Withdrawal

  

  

  401(k)

  

  Whole Life Policy Cash Values

  

  Total Money Kept

  

  Money Withdrawn

  

  $50,000

  

  $50,000

  

  

  

  Taxes Paid (28%)

  

  $14,000

  

  $0

  

  

  

  Net Withdrawal Amount Per Account

  

  $36,000

  

  $50,000

  

  $86,000

  

The example assumes a total effective tax rate of 28% at $100,000 in income and a total effective tax rate of 28% at $50,000 of taxable income. However, remember, tax brackets may be very different in the future (and if we’re at or near historic lows today which way do you think they’ll go?).

The Importance of Life Insurance Protection

So, you may now have a better understanding of account taxation. But to protect your family in the event of an untimely death, life insurance can be a core component of a comprehensive financial portfolio — providing both death benefit protection and valuable living benefits, such as access to policy cash values for supplemental retirement income.

One of the most common types of life insurance, and the one that has been around the longest, is Whole Life. Whole Life is a versatile financial instrument used for protecting families and businesses while creating and enhancing portfolio wealth.

term life insurance

Whole Life insurance

1. Allows for lifetime insurance protection through a death benefit

2. Can be viewed as a comprehensive portfolio asset in a financial portfolio

3. Contractually maintains guarantees10

4. Offers a non-guaranteed policy dividend11

5. Can create tax advantages – Life insurance is viewed as beneficial for society.

Therefore, significant tax benefits have been bestowed on it that do not apply to most other financial instruments.

These include: income tax-free death benefits, tax-deferred build-up of cash values inside the policy, and access to policy values on a tax-favoured basis

Additionally, there are other advantages to life insurance versus some traditional tax-deferred retirement options for living benefit purposes:

Funds can be withdrawn at any time without penalty

No required minimum distribution (as with certain types of retirement plans)

Loans can remain outstanding indefinitely

No IRS limits on the maximum premium (other than MEC issues)

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