As January 2018 comes to a close, the U.S. national debt exceeds $20.6 trillion and continues to increase at a very fast rate (per usdebtclock.org) .
Now, I realize there’s been a reduction in income tax rates, but I know of only two ways to reduce the national debt: 1) increase revenue by increasing income taxes and/or 2) reduce government spending.
That said, I think it’s extremely prudent to make sure you have income sources that are non-taxable at retirement. A helpful equation to use to ascertain whether it makes sense to have taxable or non-taxable investments is the following:
TE = Taxable Equivalent yield for an investor
TF = Tax-free yield
T = Investor’s marginal tax rate
TE = TF divided by (1-T)
Let’s assume Investor A is in a 28% tax bracket and is considering investing in a non-taxable investment yielding 3%. What is the taxable equivalency yield this investor must receive to equal this tax-free yield?
TE = .03/1-.28 = .03/.72 = 4.166 %
Therefore, an investor who can qualify for non-taxable investments, such as a Roth IRA and the employer-sponsored Roth 401(k) plans, can accumulate virtually 28% less of assets to generate income than someone who has the same asset base subject to taxation upon retirement.
If you agree that there’s a strong likelihood that taxes might just be higher when you are ready to draw income from your various retirement assets, then this might be a prudent way to go. I refer to this as the “paying tax on the seed rather than the harvest mentality.”
For 2017, if you are single or married and younger than 50, you can contribute $5,500 into a Roth IRA by April 18, 2018, which does not include any extensions. If you are 50 or older, you can contribute an extra $1,000.
For those who are not married, your contribution begins to phase out (or is reduced) with modified adjusted income (MAGI) of $118,000 and no contribution allowed when income reaches $133,000.
For those married and filing jointly with MAGI of $186,000 then the contribution begins to be reduced and totally eliminated when income is at $196,000.
Another solution for non-taxable income would be the employer-sponsored Roth 401(k) that allows a larger contribution of after-tax monies of $18,000 if you are under age 50.
If you are age 50 or older, you have an additional $6,000 — or $24,000 total — for an annual maximum contribution. There are no income restrictions with the Roth 401(k) plan like there are with a non-employer sponsored Roth plan.
Please note that everyone regardless of income levels can do a Roth conversion. The question or analysis that must be done prior to a Roth conversion is whether it makes sense to bite the bullet and pay the tax now for future tax-free growth and reduced tax burden later.
This should be figured taking into consideration that the IRS mandates a Required Minimum Distribution (RMD) at age 70 ½ or there’s a 50% penalty assessed!
So what other non-taxable solutions are there for those who might not qualify due to their income being too high, employer doesn’t offer the Roth 401(k), or they contribute their maximum and would just like an alternative for extra investment funds that can be set aside for future income not subject to taxation?
One other solution to consider might be a diversified and highly rated municipal bond portfolio. For those subject to the highest marginal tax rate of 39.6%, as well as the 3.8% Medicare surtax, then the taxable equivalent for a 2.5% tax-free bond is quite a bit higher.
Calculating Taxable Equivalency again:
TE = .025/1-.396 + .038 = .025/.566 = 4.41%
Lastly, a nontaxable solution I began using for my family over five years ago when I wasn’t able to qualify for contributory Roth IRA contributions is the Life Insurance Retirement Plan (LIRP) using index universal life insurance (IUL).
If designed properly, these plans can potentially far exceed other investment options due to the benefits they can offer such as: no stock market risk as the insurance company guarantees 100% downside protection; ability to participate in the majority of the upside of the stock market gains and lock this in annually; 100% creditor protection in most states; no age 59 ½ restrictions or age 70 ½ forced distributions from these plans; and if you don’t use all of the non-taxable income while living, then the death benefit goes income tax-free to your loved ones.
To top off these benefits, I was also able to structure all four of our family LIRPs so that they have accelerated death benefits should any one of my family members have a chronic illness and need to access the death benefit now for medical expenses rather than upon death.
The only catch with these plans is that not everyone can qualify medically and that there are expenses associated with them that, after some detailed comparisons, allowed me to personally come to the conclusion that the income tax “expense” in my personal situation far exceeded the contractual expenses.
I strongly urge clients to consider the tax ramifications of their retirement income planning not just now, but in the future when you are withdrawing income from those assets.
Therefore tax diversification is important and often overlooked. There are only three choices: taxable, tax deductible with taxes deferred and non-taxable. Each of these should be evaluated closely before making a final decision as everyone’s situation is unique to them.
Rich Groff II, CFP, is a third-generation certified financial planner who has been specializing with advanced planning for higher income and higher net worth individuals since 1989 throughout the United States. He often refers to his role with entrepreneurs as a Personal CFO looking at all aspects of their personal financial planning, which is often overlooked while they focus so much of their time on the success of their businesses. Rich is the author of the upcoming book “7 Common Mistakes Even Entrepreneurs Can Make & How to Avoid Them” (legacyplan4u.com). Investment advisory services provided by TheMoneyMD.com LLC, a Registered Investment Adviser.
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