As the huge baby boomer generation approaches retirement and greater pressure is placed on the Social Security system, the need for all generations to save for their own retirement is reaching an all-time high. While it’s important for people to decide how much and in what types of investments their assets should be placed for retirement income, what may be equally important for future retirees is the need to position their retirement assets so that they provide taxinsulated income. 

Why Tax-Insulated Income is Important

To prepare for retirement, people are using an assortment of tax-favored vehicles.
 Traditional IRAs, 401(k)s and other defined contribution retirement plans, defined benefit retirement plans, deferred compensation programs through an employer, Simple IRAs, SEPs, and even non-qualified deferred annuities, are all methods people are using currently to fund their retirement, some of which provide a current income tax deduction. Each of these methods has its place and is very important in providing opportunities for investments to aid people as they approach their retirement years. However, one common aspect of all of the above programs and strategies is that the retirement income generated from these sources is subject to federal, state, and possibly local income taxation. The purpose of assets set aside for retirement is to provide income for the retirees to live on. The key is not just the income generated, but the after-tax income that can be used by the retiree in retirement.

The Uncertain Future of the U.S. Tax Code

According to the U.S. Office of Management and Budget, the American government was projecting budget surpluses in 2001. Today, according to the U.S. Treasury Department, the government finds itself with the largest national debt in the history of our country – exceeding $13 trillion!

We also know that the baby boomers are fast approaching retirement age, and last year, 2010, the first wave of boomers began to retire. According to the 2000 U.S. Census, this group, currently between 43 and 61 years of age, comprises nearly 30 percent of the U.S. population. They will go from their top income years to asking for Social Security income and benefits in a few short years, putting even more pressure on the U.S. coffers.

Many people believe that federal taxes will increase. Indeed, even though Congress extended the tax cuts of 2001 and 2003 through 2012, federal income tax rates, capital gains tax rates, and estate and gift tax rates are all likely to be reviewed in light of the growing deficit. All this means a new risk is created for the upcoming retirees.

Changing Tax Code Risk

In the investment world, we hear of various risks associated with investing. Market risk, specific risk, interest rate risk, and purchasing power (inflation) risk are all fairly well known by financial and investment professionals. But what about tax risk associated with assets placed in investment vehicles that generate tax liabilities when accessed? These assets are, in essence, “tax trapped” and are subject to the vagaries of future tax code changes.

Avoiding the Tax-Trapped Strategy

Currently, the highest personal federal income tax bracket amount is 35 percent. The current capital gains tax rate is 5 percent for certain taxpayers who find themselves in lower tax brackets and 15 percent for all others. This has not always been the case, as capital gains used to be taxed at 20 percent, and federal taxes were as high as 70 percent pre-1980.

State and local governments have been disconnected from the federal estate tax code by the passage of 2001 EGTRRA, so the state’s income source through estate taxation may have been reduced. This change has put pressure on state and local governments to increase their tax rates.

Let’s assume a person is retiring and is accustomed to living on a level of income that places them at the highest tax rates in both state and federal levels and has created their retirement income exclusively from the above tax-trapped strategies. If tax brackets go back to former highs with 70 percent FIT, and state income tax rates are at 5 percent, this same retiree could find himself or herself in a situation where he or she receives a retirement income dollar and has only 25 cents leftover after taxes!

This is the tax risk associated with retirement assets located exclusively in tax-trapped strategies. Given the above example, tax diversification of retirement income seems to make sense.

Creating a Tax-Diversification Strategy

How can financial professionals help a client manage retirement assets so that they can insulate the client’s retirement income from tax attrition? Here are three ways that tax-insulated income might be provided:

1. Through a municipal bond portfolio

2. Via Roth IRAs that permit tax deferral and tax-free access under certain circumstances and limitations

3. With insurance-based retirement programs that frequently use variable life insurance contracts as asset accumulation devices

Each of these methods has unique limitations and advantages, and none of them provide a current income tax deduction.

Municipal Bond Portfolio

One way to create at least partial tax-insulated income is to invest in a municipal bond portfolio. Constitutionally, there is a separation between the federal government and the state governments. Because of this, the law protects state and municipal bond income from being taxed on the federal level. Income generated from these bonds is, therefore, free of federal income tax. This tax advantage has been around for a very long time and is expected to continue well into the future. But there are several drawbacks to relying on this strategy alone.

First, municipal bonds are fixed-income investments. If a person invests heavily or solely into municipal bonds, the desire to have a well-diversified portfolio is hindered. Most modern investment philosophies advise clients to diversify their retirement portfolios into multiple asset classes. Large-cap stocks, small-cap stocks, foreign stocks, fixed investments, and cash equivalents are frequently mentioned in a diversified investment portfolio.

For those living longer, the need to have one’s assets positioned to provide long-term growth may be important. The long-term risk of placing the bulk of a person’s assets into municipal bonds (fixed-income investment) is that this type of investment is generally not noted for equity growth opportunities.

Municipal bond income is also used to calculate the taxable element of Social Security income. In a way, the tax-favored income, in part, may trigger the taxation of Social Security benefits to retirees. Additionally, income from municipal bonds not created in the state where one resides exposes that income to state income taxation.

Roth IRA

Congress passed legislation in the past that permits people to save money on a tax-deferred basis, allowing access to the assets and earnings on a non-income tax basis. This wonderful, legally created creature of our federal government is called a Roth IRA. The great positive of the Roth IRA, as it relates to tax-insulated income, is that distributions of earnings from the Roth IRA are not subject to income taxation if:

• The owner is at least 59½

• The Roth has been held for 5 years

• They were made after the owner’s death

• The owner is disabled, or

• The distribution is for a qualified, first-time home buyer expense as long as it is not more than $10,000.

Further, you have several investment options available that would permit a person to have a diversified investment portfolio with equity exposure for the hope of long-term gains that might exceed inflation.

The Roth IRA permits people to make a nondeductible contribution to an IRA up to $5,000 per year, in 2011 ($6,000 if over age 50). So, the amount you can place into this investment vehicle is the first limitation. If you contribute to a traditional deductible IRA to reduce current-year tax liability, that amount is reduced dollar for dollar for contributions to the Roth IRA. This represents a second limitation to this strategy. The third limitation is that if you earn too much income in a given year, you are not allowed to contribute to the Roth IRA. In 2011, joint taxpayers with income greater than $177,000 and single taxpayers making more than $120,000 are excluded from this strategy for that year altogether.

Also, note that this strategy is tracked by the IRS, and you must file IRS form number 8606 to indicate you are electing to invest in a Roth IRA.

Is there a strategy that will allow a person to invest in a diversified portfolio of investments, does not have a legal limitation on the amount to be invested, does not have a legal limitation for contribution amount by virtue of how much you earn, and is not tracked on a special IRS form?

The answer is yes. It’s the third alternative, the insurance-based retirement program.

Insurance-Based Retirement Program

One way to create tax-insulated income for the client, other than through government-created and monitored programs, is to create a life insurance-based supplemental retirement strategy for a client with a life insurance need. Objectives, time horizon, and risk tolerance, as well as any associated costs, should all be weighed when considering this strategy. Variable life insurance has fees and charges associated with it that include costs of insurance that vary with such characteristics of the insured as gender, health, and age, underlying fund charges and expenses, and additional charges for riders that customize a policy to fit individual needs.

In its purest form, this strategy involves using a variable flexible premium life insurance contract in which the death benefit is the least amount possible under the law relative to the age of the owner and the amount of money to be contributed to the policy that can still qualify the policy as life insurance under the tax code. In effect, the owner is using the tax-favored features of a life insurance policy under IRC 101, 7701 et seq., and IRC 72 to create a tax-favored cash value fund with growth potential for future use in retirement. The client would want to make sure that the life insurance contract is not a modified endowment contract. This will enable the owner to access cash values for a supplement to his or her retirement income on a tax-favored basis. As always, surrender charges may apply to partial surrenders, and loans and partial surrenders will reduce the cash value and the death benefits payable to beneficiaries. If the policy were to MEC, loans and partial surrenders will generally be taxable, and if taken prior to age 59½, may be subject to a 10% tax penalty.

In that regard, the client is paying for the least amount of life insurance coverage that is possible under the law by having the lowest face coverage permitted based on age and premium contribution while still getting the tax-favored growth potential and access of the cash value. The life insurance policy is, therefore, designed to be an asset accumulation vehicle owned and under the sole control of the client.

Variable life insurance contracts generally have an assortment of equity-based, underlying sub-accounts. On one hand, you could have a well-diversified portfolio of investments for the client in this arrangement, while on the other hand, you are limited to the universe of investment choices in that particular contract. Of course, this type of investing is subject to market risk, including the possible loss of principal.

The strategy does involve the expense of the life insurance policy, which would likely include policy expense charges and the cost of insurance (COI) charge for the net amount at risk. The strategy calls for the least net amount at risk to minimize the COI.

The Payout Phase

At retirement, the insurance-based fund of cash value could be accessed for retirement income by the retiree to supplement his or her retirement income, with that income being insulated from income taxation.

The client could access these cash value monies by withdrawal of cash value (up to tax basis) and then by loan features in the contract. Many policies permit loans at or near a zero net interest loan rate.

This income would be free of seven types of potential retirement tax attrition:

1. Federal income tax

2. State income tax

3. Local income tax

4. Capital gains tax

5. FICA/Social Security Tax

6. No effect on alternate minimum taxation

7. No effect on the percentage of Social Security benefits subject to income taxation

This is not to say that various sources of retirement income are subject to all these taxes at once, rather, that certain income in retirement may be subject to one or more of these, depending on the source of the income.

Limitations of the Insurance-Based Retirement Program

Unlike the Roth IRA, there is no limit to the amount that the client could invest into this strategy other than insurability issues and life insurance company limitations. There is no special IRS legal form for the strategy, there is no 59½ age limitation, and there is no limitation based on earning too much income in the year. The monies taken from the policy are not deemed a preference item on your personal tax returns, subjecting you to alternate minimum taxation.

One limitation is that the client, or client’s spouse, would need to be insurable. Another concern is that a taxable event could occur in the withdrawal phase of this strategy if the monies taken from the policy cause the policy to lapse. This would expose the client to a taxable event equal to the amount of the excess over tax basis. This could be a sizeable taxable liability generated in the year of the surrender or lapse.

The industry is responding to this concern by having policy provisions built into the policy to reduce this risk and monitoring services to help both the investment professional and client during the income stage of the strategy. It, however, remains a concern of the strategy.

Conclusion

The need to plan for retirement through various strategies and to invest wisely is becoming increasingly important.

As we see an increasing national debt, a heavily strained Social Security system, and the likely prospect of increases in tax rates, the need to plan for tax diversification of retirement income between taxed and non-taxed income seems to be a very important area.

Under the right circumstances, municipal bond portfolios, Roth IRAs, and insurance-based retirement programs can be useful in creating tax-insulated income that can help protect your clients from the risks of a changing tax code.

Federal tax laws are complex and subject to change. Neither the company nor its representatives give legal or tax advice. Please talk with your attorney or tax advisor for answers to your specific questions.

CIRCULAR 230 DISCLOSURE: To comply with US Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax advice as contained in this communication is not intended or written to be used, and cannot be used, by any person other than Asofsp and its affiliates, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing or recommending to another party any transaction, arrangement or other matter. 

Federal tax laws are complex and subject to change. This information is based on current interpretations of the law. Neither the company nor its representatives give legal or tax advice. Please talk with your attorney or tax advisor for answers to your specific questions.