Hidden Dangers of Retirement: Taxation

Lynn Nolan

By Lynn Nolan | October 28, 2014

There is this myth that when you retire you’re going to be in a lower tax bracket. Maybe you are, maybe you aren’t. Most people focus on saving money for retirement, but few put any planning into how to withdraw the money in the most tax-efficient way.

You need to be planning now for the potential impact that income taxes might have on your retirement income.

Taxes are the big unknown in retirement planning. U.S. tax rates are among the lowest in history right now, yet we’re facing trillions and trillions of dollars in deficit. Who is to say that taxes are going to be lower when you retire ten, twenty, thirty years from now? There’s a good chance they’ll be higher. For example, in just the past few years, the American Tax Relief Act (ATRA) has increased the highest tax bracket to 39.6 percent, and healthcare reform has just imposed an additional 3.8 percent Medicare surtax on net investment income.

The threshold for the Medicare surtax is not that high: a $250,000 Modified Adjusted Gross Income (MAGI) for a couple or $125,000 for an individual, amounts that are not indexed for inflation. For anyone who plans to rely on investment income in retirement, this new surtax will affect how much you have available to spend.

I recently wrote an article for the Journal of Financial Service Professionals on the impact of the Medicare surtax on retirement income planning. There are a variety of strategies to mitigate the impact of the Medicare surtax and other taxes on retirement income, including income tax diversification, funding employer-sponsored retirement plans, deferred compensation plans, non-qualified deferred annuities, immediate annuities, municipal bonds, charitable trusts, Roth IRA conversions, and life insurance.

Life insurance can be a great tool to use in diversifying your retirement portfolio because, in the right circumstances, you can draw down the cash value of a properly funded permanent life insurance policy with no tax. This strategy works best if you are putting more into your universal life or indexed universal life (IUL) than just the minimum. While contributing the minimum covers the costs of the life insurance, and it does build up cash value, putting more than the minimum can accelerate the growth of your cash value and give you a substantial resource to draw on, tax-free, during retirement.

There are several different approaches to using the cash value of your life insurance policy. You can withdraw up to an amount equal to your contributions to the policy completely tax-free, because the withdrawal is treated as a return of principle. Beyond that, you will need to pay taxes on the gains, so the best approach at that point is to borrow against the cash value rather than withdraw from it.* If the loan is not paid back by the time of your death, it will reduce the death benefit, so talk to your financial advisor to determine the best strategy for your circumstances.

Life insurance is tax-advantaged, which is why I believe it is—- an important part of retirement income planning. Not everything you save for retirement needs to be put into a tax-deferred 401K or IRA. This is especially true with the most recent increases in taxes. Take advantage of diversifying your assets, so that in retirement you have a mix of taxable, non-taxable and tax-free income. Tax diversification is just as important as investment diversification in retirement planning. Talk to your financial advisor to plan the right strategy for your situation.

Many people have most of their retirement monies in 401Ks and IRAs. These monies grow tax-deferred but are 100 percent taxable as ordinary income when distributed. There are only a few assets that are exempt from any taxes on withdrawals, and life insurance is one of them. Utilizing the cash value in a permanent life insurance policy can offer tax control.


* If the policy is a MEC (modified endowment contract), a 10 percent penalty tax will apply if you are under age 59½.

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