It’s All About The Taxes

I love Italian subs. My wife, Jill, does not like me going out to lunch. She thinks it costs too much. What I have learned over the years, especially now, living with my wife of almost 20 years and 3 daughters, instead of standing up “like a man” arguing with women, I just agree and proceed to do what I want to do. “You’re right, honey, why would I go out to lunch?” I go anyway, which often brings me to my favorite Italian sandwich. It is made right in Falmouth across from Starbucks at “A Slice of Italy.” I know eating cold cuts is not very healthy, however, these guys make the best Italian sub I have ever tasted and they are a friendly bunch of folks as well. So, just about every Tuesday, I agree with my wife, and then proceed to slide out of my office, slip out the back door of the Cutter Building, and drive stealthily down Route 28 to go see my friends at “A Slice of Italy.”
This past Tuesday, I was waiting in line to order my sliver of paradise, and a very nice couple from Mashpee turned to me and said, “Hey, are you Jeff Cutter?” Now, knowing this conversation could go one way or the other I answered cautiously, “That is a loaded question, why do you ask?” They chuckled, and said, “We are Cutter Family Finance readers! We enjoy reading your column.” Then they said, “We Deserve More, can we ask you a question?” I laughed, “Of course.”
John and Sandy wanted to know whether taxes need to be considered for proper retirement planning. Specifically, they wanted to understand how to convert their taxable money to non-taxable money. They asked if there are strategies to do this.
In many cases, it is all about the taxes. I began by asking John and Sandy four questions that I always ask my clients (and that I encourage you, my Cutter Family Finance readers, to ask yourselves).“Do you think taxes will be higher in the future? Do you think Social Security and Medicare benefits will be lower in the future? Do you believe inflation will be a significant problem in the future?” And last, “Will volatility harm your investments and threaten your ability to retire or stay retired?” John and Sandy answered yes to all of those questions. Lastly, I explained that while these are all questions everyone should ask themselves, they are very smart to be questioning the impact that taxes will have on the success or failure of their investments and retirement.
I realized that the answers John and Sandy were seeking would take more time to explain to them, so I decided to put my Italian sub on hold, excused us from the growing line, and we sat down to talk. I explained to them that in my opinion, although no one ever wants to pay taxes, paying them now could be more advantageous than paying taxes in a much higher tax environment in the future and the financial services industry does a poor job explaining why.
I told John and Sandy that there are a few things they can do to convert their portfolio to non-taxable investments today, while minimizing their tax exposure. In fact, one significant benefit in the tax code today is the tax benefit afforded to cash value life insurance.
There are two general categories of life insurance, term life insurance and cash value (or permanent) life insurance. Term insurance is pretty straightforward; it pays a death benefit to beneficiaries if the insured dies during the term the policy is in force. A cash value policy, on the other hand, is generally designed to provide life insurance coverage, which generally covers the insured’s entire life. Some cash value policies will even have an option for long-term care benefits.
I explained to John and Sandy that there are some significant tax advantages to cash value life insurance if it is structured properly. One benefit is that you pay NO current income tax on interest or other earnings credited to cash value. As the cash value accumulates, it is not subject to current taxation. A nice feature in a rising income tax situation.
Another benefit is that the owner of a cash value life insurance policy pays NO income tax if he or she borrows cash from the policy through loans. Generally, such loans are treated as debts, not taxable distributions. This can give a policy owner virtually unlimited access to funds up to the cash value on a tax-advantaged basis. Furthermore, these loans need not be repaid. After a sizable amount of cash value has accrued, it can be systematically borrowed against to help supplement retirement income, and in many cases, never pay one cent of income tax on the gain.
There are, however, several reasons to be cautious about loans from cash value policies. First, loans are charged interest and so they can reduce the overall value of the policy not only by the amount of the loan, but by the amount of interest charged on the loan as well. Second, the cash value is potentially subject to income taxes if there is a withdrawal from or surrender of the policy, or if a certain ratio of death benefit to cash value is not maintained. Third, if the cash value policy is a modified endowment contract, a loan from such a policy may be taxable. Make sure you seek a qualified professional in this area if you choose to obtain a cash value life insurance policy or take a loan from such a policy, because if such a transaction is not structured properly, you could be facing a taxable time bomb.
Lastly, it is important to know that, if you (A) own your policy at the time of your death or (B) make your estate the beneficiary, the policy proceeds will generally be included in your estate at death. This can increase the value of your estate, triggering estate tax ramifications.
You can, however, avoid potential estate taxes and probate costs on cash value policy proceeds, as long as the beneficiary designations and policy ownership are arranged in accordance with current law. I reached out to Geoff Nickerson, partner at the Falmouth law practice of Oppenheim and Nickerson, LLC. Geoff says, “One solution to possibly avoid 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.” Great advice Geoff, and yet another reason why proper estate planning is so crucial to a sound financial plan.
From my conversation with John and Sandy I learned that they are both healthy 62 year-olds and file their taxes jointly. They claim the standard deduction on their taxes of $14,200 and each qualify for their full personal exemption of $3,800 each which gives them a total of $21,800 in tax deductions. They live on a combined Social Security benefit and their Required Minimum Distribution (RMD) of about 10K from an IRA.
I explained to John and Sandy that they could withdraw about 12K more per year from their IRA and still pay no or minimal income tax on the withdrawal. Therefore, if nothing changed, they could eliminate or significantly reduce taxes on about $240,000 over a 20-year span. They could relocate that $12,000 per year into a cash value life insurance policy that could assist in long-term care. Or, that money could fund an annual premium for a cash life insurance policy of substantial value after a period of several years that could provide both a death benefit and access to their cash value.
After some time had passed, I explained to John and Sandy my lunch situation with my wife. I explained how by “agreeing with her and proceeding to go anyway” had given us the opportunity for to meet, I had to cut our meeting short or risk getting caught. So I told them to stop down some day so we could chat more about their situation.
In anticipation to our meeting, I gave them an assignment to read Pat Kelly’s book, The Retirement Miracle. Needless to say, I did order and eat the best Italian sub in the world and slipped stealthily back to my office safe and sound. Another successful week of agreeing and proceeding.
Be vigilant and stay alert, because You Deserve More!