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Life Insurance Benefits

Life Insurance Benefits of a Roth IRA vs. Life Insurance for Tax-Free Retirement Income

Taxes are a part of our lives from start to finish. This includes the taxation that you can incur on your retirement income. That’s why it is important to generate tax-free income in retirement – and two of the primary sources that allow you to do so are the Roth IRA and cash value life insurance. Both of these financial vehicles have various advantages and drawbacks, though. So, it is recommended that you have a good understanding of the benefits of the Roth IRA versus life insurance before you make a long-term commitment to either (or both).

The Impact of Taxes on Your Retirement Income

Just like during your working years, it is probable that you will owe income tax on at least some of the money you access in retirement. In some cases, you may owe capital gains tax. Capital gains tax is levied on the positive difference between the original price of an investment and the profit you made. Capital gains can be long-term or short-term, depending on how long you held the asset. For example, long-term capital gains taxes are levied on the profits from the sale of an asset that was held for more than one year. Depending on your tax bracket, long-term capital gains tax rates (in 2020) are 0%, 15%, or 20%.

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Income Tax Rates (in 2020)

Tax Rate Taxable Income Single Tax Filer Taxable Income Married Filing Jointly 10% Up to $9,875 Up to $19,750 12% $9,876 to $40,125 $19,751 to $80,250 22% $40,126 to $85,525 $80,251 to $171,050 24% $85,526 to $163,300 $171,051 to $326,600 32% $163,301 to $207,350 $326,601 to $414,700 35% $207,351 to $518,400 $414,701 to $622,050 37% Over $518,400 Over $622,050 Source: Short-term capital gains tax applies to assets that are held for one year or less. These are taxed as ordinary income. Based on your tax-filing status and the amount of income you earn, these rates can be anywhere from 10% up to 37% (in 2020). Income isn’t only taxed when you earn wages, though. You can also owe tax on the income you bring in during retirement from interest and dividends, annuities, and even from your Social Security benefits in some situations. Nobody knows what income tax rates will be in the future. But, given the historically low tax environment in the U.S. over the past decade or so, it is far more likely that rates will go up rather than down. In fact, the current top federal income tax rate of 37% (in 2020) is actually quite low when considering that over the past century, this rate has been in excess of 70%, 80%, and even 90% in multiple years.

Top Federal Income Tax Rates 1913 – 2020

Year Rate Year Rate 2018-2020 37 1950 84.36 2013-2017 39.6 1948-1949 82.13 2003-2012 35 1946-1947 86.45 2002 38.6 1944-1945 94 2001 39.1 1942-1943 88 1993-2000 39.6 1941 81 1991-1992 31 1940 81.1 1988-1990 28 1936-1939 79 1987 38.5 1932-1935 63 1982-1986 50 1930-1931 25 1981 69.125 1929 24 1971-1980 70 1925-1928 25 1970 71.75 1924 46 1969 77 1923 43.5 1968 75.25 1922 58 1965-1967 70 1919-1921 73 1964 77 1918 77 1954-1963 91 1917 67 1952-1953 92 1916 15 1951 91 1913-1915 7 Source: Inside Gov ( Given the possibility that you could have some – or even a majority – of your retirement income taxed, it is important to generate as much tax-free income as possible. That way, regardless of what the future income tax rates are, you’ll be able to put more income in your own pocket, as versus into Uncle Sam’s.

Tax-Free Retirement Income Sources

When it comes to having more spending money in retirement, one strategy is to reduce – or even eliminate – your income taxation. Some of the ways to do so include generating interest from municipal bonds and waiting to file for Social Security benefits until after you have reached your full retirement age. You can also generate tax-free retirement income through a Roth IRA (Individual Retirement Account), as well as by taking advantage of cash value life insurance. It is important to understand the difference between the potential drawbacks and the benefits of the Roth IRA versus life insurance, though, so that you are able to maximize your incoming cash flow in retirement. Generating Tax-Free Income with a Roth IRA Roth IRAs are funded with after-tax dollars. So, unlike with a traditional IRA, you are not able to defer taxes on the contributions you make into a Roth. However, the funds inside a Roth IRA are allowed to grow tax-free – and the withdrawals are also made free of income taxation after the 5 year period– regardless of the income tax rates at the time you access these funds. While the Roth IRA can certainly offer some enticing tax-related benefits though, these accounts can also have some limitations. For example, there is a maximum annual contribution limit. So, (in 2020), if you are age 49 or younger, you can only contribute up to $6,000. If you are age 50 or over, you are allowed to add an additional $1,000. Also, there are income limitations posed on Roth IRA accounts. Therefore, if you earn “too much,” you may only be allowed to contribute a portion of the annual maximum – or you may not be able to contribute anything at all.

Roth IRA Income Limits (2020)

If your tax filing status is: And your modified adjusted gross income is: Then you can contribute: Married filing jointly or qualifying widow(er) Less than $196,000 $196,000 to $206,000 Above $206,000 Up to the limit A reduced amount Zero Married filing separately (and you lived with your spouse at any time during the year) Less than $10,000 Greater than $10,000 A reduced amount Zero Single, head of household, or married filing separately (and you did not live with your spouse at any time during the year) Less than $124,000 $124,000 to $139,000 Above $139,000 Up to the limit A reduced amount Zero Source: Even if you earn “too much” to qualify for a Roth IRA, there may still be a way to open and fund this type of account. This is through a “backdoor” Roth IRA. A backdoor Roth can be created by first contributing to a traditional IRA account and then immediately converting it to a Roth. Because strategies like the backdoor IRA can be somewhat tricky, though, it is recommended that you first discuss all of your options – as well as your short- and long-term financial objectives – with a retirement planning specialist who can guide you through the process. Life Insurance Tax-Free Income Strategies Believe it or not, another primary source of tax-free income in retirement is cash value life insurance. Permanent life insurance policies have both a death benefit and a cash component. The funds that are inside of the policy’s cash value are allowed to grow on a tax-deferred basis. These funds can earn interest on the contributions and interest on the previous interest and interest on the funds that would otherwise have been paid in taxes. But unlike other types of tax-deferred financial vehicles – where the funds are taxed upon withdrawal – there are strategies that can be used for accessing the cash value of a life insurance policy tax-free. One option is to take a policy loan (as versus a taxable withdrawal). By borrowing the funds from the cash value versus withdrawing them, you will not owe tax on the money you receive. In addition, unlike most other types of loans, you don’t necessarily have to repay this loan – at least not in your lifetime. Rather, upon the death of the insured, money from the policy’s death benefit can be used for the loan repayment. (It is important to note that interest will still accrue on the unpaid loan balance over time.) Then, the remainder of the death benefit can be received, free of income tax, to the policy’s beneficiary. Not all life insurance policies will work for generating tax-free income in retirement, though. In addition, it is possible that you may not qualify for a policy based on health criteria. With that in mind, it is important that you work with a financial advisor who is well-versed in both life insurance and retirement income planning before you move forward with this or any similar strategy.

Is a Roth IRA or Cash Value Life Insurance Policy Right for You?

Generating tax-free income in retirement can put you in more control over how much you bring in, and in turn, how much you are ultimately able to spend. But setting up various strategies can involve very specific processes, so it is essential that you work in conjunction with an insurance or financial professional who is familiar with these strategies and point you in the right direction regarding which options may or may not be best for you. If you would like to set up a no-obligation strategy session with a retirement income specialist, please feel free to reach out to us directly by phone at phone number or via email at [email protected] and let us know what date and time work the best for you.

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