Planning For Retirement Using Investment And Income Tax Strategies (Part 1)

Planning for retirement and accumulating money for that future event is important for many people.  Their concern is to make sure they have enough capital to turn into cash and use as an income payment.  Another consideration is to make sure they don’t outlive their income, as their retirement could last longer than their working career.  

Many retirees will require a substantial amount of capital to provide the income needed to maintain their retirement lifestyle.   Most of the capital is focused on retirement programs, such as 401k/403b, IRAs, and other company sponsored plans.  

The focus is on saving and investing during the accumulation stage, picking investments that compliment what they think will create the capital needed at their target retirement date.  Because of this mindset I find that many people are putting their assets in one investment basket strategy.   By only thinking about an accumulation strategy, they are missing the mark on “net spendable income”, the true driver of their standard of living. They also need to also consider tax diversification strategy in order to accomplish the desired result.  

When people “cash out” at retirement for income, they are surprised to hear their qualified company plan is taxed at 100% of every dollar withdrawn, and that they are forced to take the money (through Required Minimum Distribution). They received a tax deduction on their contribution, which is a very small part of the total retirement pie.  Taxes are the single most expensive part of your retirement, and the component that is planed for the least. 

When consulting with our clients, we suggest they plan the two strategies in conjunction with each other.

  1. The accumulation of assets through investment or “The What”. Such as funds or accounts they wish to invest in.   
  2. The tax ramification of the investments– this is the “The Where”.  Such as IRA, 401, ANNUITY, LIFE INSURANCE – OR THE TAX RAMIFICATION, and the tax effects of each of them. 

There are two risks, investment risk, and tax risk which will erode your retirement nest egg.  

As you plan your retirement and investment you should think about the following: :

a. Diversification of the investments, this is called asset allocation. The purpose of this is to avoid as much risk as possible, while attempting to gain a consistent rate of return. 

b. Income tax diversification:  this is the “where” you have your funds and how will they be taxed when they are turned into cash. 

Taxes are unavoidable and income tax rates change. The assumption is they will be higher than now because Uncle Sam is always looking for more revenue, and normally the higher income earners foot the bill. 

With some of the products of today, you can minimize taxes, and in situations eliminate them altogether. 

When people invest in high taxable investments they have  no options when they distribute the funds to provide an income, they end up paying much more in taxes than if they had a strategy. 

 Part of our strategy is to have our clients recognize the consequences of putting all their assets in “one basket” for income purposes. They need the knowledge of how an investment can be “tax wise”, allowing them to blend their strategies for a lower net tax result.  

An example:  Sam grows his 401k to $600,000.  He can take income from the 401k of $44,149 a year for 20 years, assuming 4% ROI. The tax rate is 33% (state and Federal) as he has a pension and rental income, and his wife has a payout.  By having all of his assets in a taxable account, he will pay $14,569, for a net of $29,579. 

However, if he did some planning, he could have deposited money in a more efficient tax account where the payout would be tax free.  Let us say Sam invested enough money to provide $29,579 in his 401K AND he put the extra in his specially designed 7702 life insurance policy which gave him $14,569 tax free income.  Sam would only pay the taxes on the $29,579 or $9761, $4807 less in taxes.

Observation: 

Because most of the money was in a qualified plan (401k), Sam didn’t have the option of creating tax-free income. He could have converted some of the money to a Roth, however, he would have had a tax liability.  

Tax-strategy planning: is most important to retirees who will have to replace their income in the future. Diversification of retirement assets gives the retiree the option of deciding when the best time to sell, exchange, liquidate or annuitize asset classes.  

Reasons why income tax diversification is important

  1. Retirement can last a long time- in some cases longer than you have worked
  2. Limited working ability 
  3. Investments fluctuate in value
  4. The law changes over time- consequently so do tax rates

Income taxes have the greatest impact on your income, so it’s not as important as to the value of the asset as much as the tax structure of the payout of the asset.  

A cash rich life insurance policy may not grow as great as a mutual fund given the same amount of contribution over time.  However, when income is taken from the policy, it is tax-free.  The mutual fund withdrawal is taxed in some form, either partially, or 100%, depending on the where it was invested (IRA or personal holdings). Consequently, you don’t need as much value in the life insurance to give more tax-free income then the after-tax income from the investment.  

There are five ways to purchase retirement funds

  1. Personally
  2. Roth IRA Individually or through 401k Roth
  3. IRA – tax deduction
  4. Investment in a sub-account inside a variable annuity
  5. Life insurance variable, indexed or permanent

Some types of investment can be tax differently depending on where you purchased them. Life insurance and Roth accounts can create tax-free withdrawals.  

An IRA is 100% taxed upon withdrawal, the same as a qualified pension plan, 401k, 403b. 

Personal investments are partially tax-free(basis), while the other parts of the investment can be ordinary taxes, or capital gain. 

There are also Tax Elements to consider.  

  • Tax deductible contributions: like IRA, 401K/403B
  • Deferment of taxation such as qualified plans, IRA, Roth’s, life insurance, annuities
  • Non-Tax deductible, deferred taxation, and tax-free payouts, like life insurance and Roth IRAS

So it is important to understand “where” you are putting your retirement money, when considering investment and tax strategies. 

Phase 2.  Will discuss the retirement strategy of payout…. 

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