“There are only two guarantees in this life, death and taxes.” This popular saying is usually attributed to Benjamin Franklin circa the 1780’s but has certainly come into much wider use since the establishment of the IRS in 1862. It is also a favorite of most financial advisors focused on retirement income planning for obvious reasons—death and taxes are key considerations when making financial decisions for your future.
While traditional methods of investing, such as 401(k)s and IRAs, do allow for initially saving money tax-deferred for retirement, taxes will be due at the time of withdrawal. Additionally, these funds place caps on your investment levels. Where, then, can you turn for a tax-free alternative that is not hampered by pesky contribution limits to maximize your wealth to use in retirement?
Life insurance is a vastly underutilized opportunity for maximizing and maintaining wealth for your retirement—tax-free under many circumstances. For instance, you can draw tax-free retirement income from your life insurance policy if you structure it correctly with the help of an expert advisor.
In short, there are two ways to die rich: maximize your wealth and pay less in taxes. If you are already investing some of your income now to be used in the future, it’s time to explore the strategies below for decreasing your taxes as well.
What Are the Life Insurance Income Rules and Their Impact on Taxes?
Taxation is a fact of life, and life insurance is no exception. If you choose to take money out of or take a loan against your life insurance policy, you could be facing some taxation on that withdrawal. However, if you utilize the rules that the IRS has laid out for life insurance policies and solicit the help of a trusted insurance expert, you could guarantee tax-free retirement income by purchasing life insurance. The IRS has set up TAMRA rules (ie. the Technical and Miscellaneous Revenue Act) which allow policyholders to take a tax-free loan against an overfunded life insurance policy, provided the policy passes their 7-pay test.
The 7-Pay Test
The total amount of money that can be put into a life insurance contract during the first seven years are determined according to law by the insured’s age, the cost of insurance, or mortality charges, the health risk rating, and assumptions about future mortality and interest rates.
While referred to as the 7-pay test, the number of payments made is of little consequence. It is the cumulative premium payments that may be made in the first 7 years of a life insurance contract that matter. Each of the first seven years additional premium is allowed according to TAMRA rules. If there is excess premium allowed from one year, it carries over to the next.
The 7-pay calculation can be complex, but fortunately will be given to you by your insurance company or agent, and a warning will be given if this amount is exceeded. Generally speaking life insurance companies will allow you to withdraw the excess premium if this amount is exceeded, as long as certain rules are followed. Otherwise, a policy will be considered a MEC, and the tax treatment of that policy will be forever changed.
The 7-pay test is used to test life insurance contracts in three distinct situations:
- During the first seven years of a life insurance policy’s life to test total premium payments.
- To re-test policies if the death benefit is reduced, which will reduce the aggregate 7-pay maximum.
- To re-test any policy which undergoes a material change (generally a change to death benefits or costs of insurance).
After a life insurance policy is considered a modified endowment contract, it can not be reclassified as a standard life insurance contract again. This is true even if changes are made to the policy which would otherwise not cause the policy to become a modified endowment contract. Because of this permanent classification, clients must always be aware of the tax consequences if they are in danger of over funding a policy under TAMRA.
How to Protect Your Assets from Taxes and Risk While You Grow Them for Retirement
One of the most significant reasons why investors exhibit risk aversion in their investment portfolio is the need to offer safety and security to their loved ones. Most can agree that they would rather take less risk in the stock market in return for a more reliable estate planning strategy and financial asset protection. However, what many fail to realize is that they can actually ensure their investment portfolio by leveraging life insurance solutions as a tax-free investment alternative for estate planning.
If you could guarantee that your family or heirs would receive a guaranteed payout, tax-free, upon your death, would you choose to take some additional risks with your market investments in order to potentially obtain a higher yield year over year? If you couple financial protection for your family with a guarantee of tax-free retirement income for yourself by leveraging a life insurance policy, with advice from a trusted insurance advisor, you are left with a win/win scenario.
If you couple financial protection for your family with a guarantee of tax-free retirement income for yourself by leveraging a life insurance policy, with advice from a trusted insurance advisor, you are left with a win/win scenario.
In addition, using a properly structured life policy to accumulate money for tax-free income purposes later also provides a self-completion feature through the death benefit in the unfortunate event you do not get to complete your savings plan. Unlike typical investment and savings strategies that simply fall short if your strategy is permanently or seriously interrupted, the use of a life policy to create a retirement income strategy offers a large and tax-free lump sum upon death that saves the day.
How to Leverage Life Insurance for Tax-Free Retirement Income
How can you leverage life insurance for tax-free retirement income—and when does it make financial sense to do so? You can utilize this strategy if you are able to pass the 7-pay test, as described above. An insurance expert should be able to run these calculations for you prior to purchasing your life insurance policy to ensure that you will be compliant with these rules and therefore not in danger of qualifying for a Modified Endowment Contract. This applies whether you plan to make a single payment or plan to pay each year over time.
This strategy makes sense if you would like to contribute a larger portion of your income toward your retirement while receiving a tax benefit in the process. It is also beneficial if you want to couple your retirement savings with built-in guaranteed asset protection. You can then draw tax-free retirement income through your life insurance policy via a tax-free loan at the time of your retirement.
It is … beneficial if you want to couple your retirement savings with built-in guaranteed asset protection.
Clients can even ask us to illustrate what they need to pay each year while they are working so that they can draw an annual tax-free income of $75,000, $100,000, or even more during their retirement years. Clients can literally dial in a “target income” that will be compliant with TAMRA rules and provide both the peace of mind of a large death benefit, as well as the potential for future tax-free retirement income that can supplement pensions and social security income.
As a savvy, proactive investor, you likely already have a trusted tax professional on your side who is able to offer you advice on your personal finances. However, most tax professionals don’t fully understand the life insurance industry and its available products—or the tax code surrounding them and how they are treated by the IRS. Our team of insurance professionals are experts at both. In fact, we have built our company around strategies that my own family has used to create, maximize, and preserve wealth. We want to help you protect your assets while you’re alive and leave a legacy when you’re gone.
The team at Howard Kaye Insurance has been advising clients on annuities, estate planning, and life insurance for more than 55 years. We have developed strategies specifically for using life insurance to leverage tax-free income for your retirement. Contact a Howard Kaye advisor at 800-DIE-RICH to discuss how to guarantee yourself tax-free income by purchasing life insurance.
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