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I Want Tax-Free Income!

26293871_sBob and Joanne from Sandwich recently e-mailed me with a concern. Bob and Joanne are in their early 50s and are worried about the impact of increasing taxes on their future income. They believe that increasing taxes could negatively affect their retirement lifestyle. I also learned that Bob and Joanne are ahead of the game. They have paid off their mortgage and they maximize their retirement contributions. Bob and Joanne asked whether they can convert some of their taxable (Traditional) IRA money now to tax-free money without getting crucified by Uncle Sam. They want to know if there any strategies that they can use to minimize the effects of increasing taxes on their investments. Basically, Bob and Joanne want to know how they get tax-free income in retirement.
 
Generally, there are two ways to convert taxable assets into tax-free retirement income. The first is a Roth conversion. This is when pre-tax savings from a Traditional IRA or employer-sponsored retirement plan, such as a 401(k), 403(b), or governmental 457(b), are converted to a Roth IRA. When this is done, the pre-tax savings are included in taxable income during the year of conversion. This allows for future tax-free growth in a Roth IRA.
 
Roth IRAs offer a number of potential advantages over Traditional IRAs. While Traditional IRAs allow for tax-deferred growth of retirement assets, Roth IRAs generally allow for tax-free growth of retirement assets, provided withdrawals are made after age 59 1/2, and the Roth has been held for at least five years. (Distributions from either Traditional IRAs or Roth IRAs may be subject to a 10 percent federal tax penalty if they are taken prior to age 59 1/2.) Another benefit of Roth IRAs is that distributions are never required. (Traditional IRAs require minimum distributions beginning at age 70 1/2.) As a result, a Roth IRA can be used as an estate-planning tool because the assets can be passed on tax-free to beneficiaries. Lastly, diversification of the taxable classification of retirement assets allows for more flexibility to manage taxable income in retirement.
 
Generally, a Roth IRA conversion makes sense if the converted Roth funds will not be needed for at least five years, you expect to be in the same or a higher tax bracket during retirement, and if the conversion taxes can be paid without using the IRA funds being converted.
 
Now, there are a couple of things to think about before converting. As mentioned above, the benefits of a conversion are increased if the income taxes due can be paid out of non-IRA assets. Also, to help manage the resulting income taxes, a partial conversion should be considered. There is no limit to the number of conversions allowed. Therefore, converting smaller amounts over several years may make sense. Lastly, if you are thinking about a Roth conversion, consider your time horizon. Generally, if you will need the funds within five years, converting to a Roth IRA would not be recommended. This is because a five-year waiting period is required before earnings can be withdrawn both income tax free and penalty free. The longer the assets in a Roth IRA can be left untouched, the greater the benefit of tax-free accumulation.
 
Another way to generate future tax-free income—and a possible solution for Bob and Joanne—is to purchase cash value life insurance.
 
You see, there are two general categories of life insurance, term and cash value (or permanent) life insurance. Term insurance is pretty straightforward; it pays a specified death benefit to beneficiaries if the insured dies during the term the policy is in force. While cash value life insurance, on the other hand, is also designed to provide a death benefit for the insured, which is paid out upon the insured’s death, no matter when he or she dies, there are also some significant tax advantages if a cash value life insurance policy is structured properly.
 
One such tax advantage is that interest and other earnings credited to cash value are not subject to current income taxes. The cash value accumulates, without being subject to current taxation.
 
Another tax benefit to cash value life insurance is that money borrowed from the cash value through policy loans is not subject to income tax if structured properly. Generally, loans are treated as debts, not taxable distributions. This can give a policy owner virtually unlimited access to the cash value on a tax-advantaged basis. Also, these loans need not be repaid. Yes, you read correctly. After the cash value has grown a sizable amount, it can be borrowed against systematically to help supplement retirement income and in many cases, never be subject to one cent of income tax on the gain. Several cautions regarding policy loans: first, loans are charged interest and policy loans can reduce the overall value of the policy; second, the cash value is potentially subject to income taxes when there is a withdrawal from or surrender of the policy, or if a certain ratio of death benefit to cash value is not maintained; and third, if the policy is a modified endowment contract, the loan may be taxable. Please, make sure you seek a qualified professional if you are considering cash value life insurance, because if it is not structured properly, you could be facing a taxable time bomb.
 
Another benefit to cash value life insurance is that generally, heirs pay no income tax on the proceeds. (This is true with term life insurance as well.) Beneficiaries receive death benefits completely free of income taxation. Therefore, a policy with $500,000 in cash value transfers $500,000 of wealth tax-free to the beneficiaries. (Also, life insurance proceeds can be transferred outside of probate if beneficiaries are designated.)
 
On the other hand, the proceeds of any life insurance policy may be subject to estate taxes if you (A) own your policy at the time of your death or (B) make your estate the beneficiary (in which case the proceeds will also need to go through probate). This can increase the value of your taxable estate, thereby potentially triggering estate taxes. I reached out to Geoff Nickerson, partner at the Falmouth law practice of Oppenhiem and Nickerson, LLP to ask how to minimize any potential estate taxes resulting from life insurance proceeds. Geoff explained, “One solution to the estate tax issue is to divest yourself of ownership of the policy using an irrevocable life insurance trust. The trust will serve as the owner and the beneficiary of the policy, and the trustee will distribute the proceeds according to the terms of the trust. To avoid inclusion in your estate for estate tax purposes, the policy must be transferred to the trust more than three years before your death.” Good advice, Geoff. He gives us another reason why proper estate planning is so crucial to a sound financial plan.
 
Folks, it gets tricky out there, so be vigilant and stay alert, because you deserve more.