The
Tax Problem No One is Telling You About
You
have been saving
diligently now for many years, looking forward to the day, not too far down the
road, when you can retire and begin living off those hard saved dollars. You
have done everything the gurus and planners have told you to do. You have used
the vehicles they suggested, invested in the products they sold and taken
advantage of every tax saving
idea you have read about. You were even smart enough to move into cash in March
of 2000 (well, maybe not that smart). You are going to be ok though, right?
Maybe not!
Regardless if this is you or you have been planning to save for retirement as
soon as you get that last bill paid off, it is time for you wake up to the tax
problem that nobody mentioned to you until now.
How many times have you heard or been told that you are going to be in a lower
tax bracket when you retire? Is that true and do you believe it? If it is true
then putting all of that money into those tax-deferred vehicles may still be a
good idea, but if it is not true, what are you going to be looking forward to?
Let’s start with some simple logic. First, what sort of income would you like
to live on in retirement? My guess is that you would like to keep your standard
of living about the same as it is today. What is your current tax bracket and
how many deductions do you currently have? Most people have at least a mortgage
deduction and if the kids are still at home
you get a deduction for them. If you are smart you might even have a home
based business that affords
a few more deductions. So, you have current income (fully taxed) and current
deductions.
What
are you hoping or planning will happen before retirement? The kids are gone (and
not coming back), the house is paid for and your income is replaced by your
investments, right? Great plan but what happens to your taxes
if your dream comes true? Every dollar coming in is fully taxed and you have
lost every deduction you had. Does that sound like you being in a lower tax
bracket?
Now let’s think through a little more of the problem. There are about 80
million baby boomers out there getting ready to join you in retirement.
According to the Congressional Budget Office
about 50% of them are on track to save enough money but are unlikely to
experience the kinds of returns their parents did. In addition, there is no
guarantee that the public benefits that were paid to your parents will be there
for these future retirees. They are also likely to live at least 2 years longer
in retirement than their parents which means that they will need either more
assets or better growth of their assets if they want to maintain their
lifestyles.
If you got from the last paragraph that there are also 50% who have not saved
enough for their retirement then you are starting to get the picture that taxes
may well be going up just when we need more money to fund our retirement and
that as more and more boomers retire that need will only increase. This, my
friend, is the part no one is talking about and this is the dilemma you will
need to address for yourself, now, regardless of how close retirement is to you.
Does it make
sense to be shoveling extra dollars
into those tax-deferred savings plans if you know that just when you need to
pull it out it is going to be taxed at rates even higher than today? Do you
realize that if you live a normal retirement (from 65 – 85) and tax rates just
stayed the same, you will pay 10% more in taxes
on the money coming out of these plans as you saved by putting it in those
plans? What kind of retirement planning is that?
So, what is a boomer to do? If what I just laid out makes sense to you, then you
have only a couple choices in front of you to overcome this problem. First, stop
overfunding your 401k plans. Put in whatever amount your company will match but
don’t keep compounding your future tax problem by adding more to it. Next you
could begin putting more money into your taxable accounts. At least this way you
will be paying taxes
at current rates and you can hope that congress will leave the capital gains
rates alone for your entire retirement.
A better choice is to begin using vehicles that can create tax-free income in
retirement. There are several that you should look into. First, you should be
funding your Roth IRA if you can. You must be making less than $160,000 per year
in joint income to be eligible though. If you can’t fund a Roth you might
consider moving
some or all of your IRA or 401k money into a Roth in 2010. That year anyone can make
this conversion and have 2 years to pay the taxes
on the transfer. This will effectively take that money and tax it at today’s
tax rates and allow you to continue to grow it and use it tax-free in the
future.
The next idea may sound strange but hang with me here as this might just be the
real winner. Why not create a private retirement plan using cash value life
insurance? If you have never considered this idea let me explain the benefits.
First, life insurance, if properly structured, can create a nest egg that can
grow tax-free, be accessed tax-free and passed on to your heirs tax-free. There
is no limit to how much you can put into it, no requirement to ever take it out
and the money is taxed only once, when it goes into the policy.
If we are using this as a cash accumulation vehicle we will want to structure it
to be the most efficient it can be. We do that by buying the least amount of
protection while putting as much money into the policy as fast as the tax laws
will allow us to, without causing it to be classified as a modified endowment
contract. A modified endowment contract functions much like an annuity which
means that any money we take out will be taxed instead of being tax-free. If it
is structured properly and held for 20 years or longer the internal costs are
not much more than the average loaded mutual fund, about 1.5 to 2%.
There are also some great benefits to creating this supplemental retirement
concept. Unlike your IRA or 401K, there are no restrictions on how or when you
use the money inside the contract. You can even use it as your own banking
source once it is fully funded. Why borrow money from the bank to purchase your
next car or send your kids to college
when you can borrow it from yourself, and pay it back to yourself. Your money is
fully protected from lawsuits and creditors in most states and the dollars
inside the policy never show up on college
financial aid forms. And when you are ready to tap into it for retirement
income, you can create a tax-free income stream that could be at least 50%
greater than what you could create from those tax-deferred accounts.
If this idea makes sense to you, you will want to talk with someone who knows
how these policies need to be structured and what type of policy would be the
most advantageous for you. Regardless of what you have done in the past to plan
for retirement, you should consider the ideas here as a way to overcome the tax
problem no one has told you about, and to take control of your own financial
future.
Marc Cram
is a CERTIFIED FINANCIAL PLANNER® in
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