Income Planning For Rising Taxes

The Bush Tax cuts are set to expire in January of 2013, which will prove to be a major problem for many investors.  This is especially true considering we have spent more money as a nation over the last 4 years than any other time in US history, bringing the debt toll to over $4.5 trillion since 2008.  This drastic spike in spending is likely to be followed by a steady increase in Federal income taxes.  It’s not a question of if, only a question of when.

Since 1913 the average marginal tax rate has exceeded 60%, and today our Federal income tax bracket caps out at 35%.  Considering we are at almost half the average Federal tax rate today, what do you think is likely to happen with Federal income taxes moving forward?  It doesn’t take a rocket scientist to figure out that the only way to offset our federal deficit is to decrease spending and raise taxes.  Moving forward, especially with the excessive Federal stimulus, I am of the opinion that decreased spending is going to be more of a dream than a reality.   

Do you have a contingency plan in order to offset rising taxes?  Most Americans are unprepared to deal with a decrease of net spendable dollars due to inflation and rising taxes coming around the corner.  Today, most retirement plans are 100% taxable upon withdrawal and cannot be withdrawn prior to 59 ½ years old without a penalty.  These are pretax dollar funds that are usually accumulated through an IRA, 401k, or equivalent deferred compensation vehicle.  Although these vehicles grow tax deferred, they are subject to ordinary income taxes upon withdrawal.  Not to mention after 70 ½ years of age the IRS makes it mandatory that every citizen who owns a pretax dollar account must withdrawal a certain percentage, known as required minimum distribution. The traditional way of financial planning taught investors to minimize their current tax bracket with the assumption they will be paying less taxes in retirement.  With the amount of Federal stimulus we’ve had over the last 4 years, that reasoning is out the window.  These are some of the reasons why many younger investors, and those preparing for retirement in the next 5-10 years, are looking to post-tax deferred compensation plans that can allow for withdrawals exempt from Federal income tax (if properly structured). 

Life insurance products such as Indexed Universal Life (IUL) are being utilized as deferred compensation plans in order to offset rising federal income taxes, market volatility, and the threat of hyper inflation.  Deposits into IUL policies are post tax dollar funds, meaning you have already paid Federal income tax on the money you deposit into these products.  Funds within this policy grow tax deferred, and there is no restriction on what age you can withdrawal the funds out at.  Furthermore, there is no restriction on the amount you can deposit annually; unlike an IRA.  Since all IUL products are life insurance policies that come with an accelerated death benefit, the policy owner is able to withdrawal the funds exempt from Federal income taxes through a loan that they take against the death benefit (assuming the policy is structured as a non MEC from the start of the policy).  Since the policy owner is taking a loan against themselves, interest on the loan is not deemed payable on an annual basis.  The interest on the loan will accumulate at a low interest rate that is not due until the death of the contract owner (the policy owner has the option to pay off the interest at their discretion during their lifetime).  At the time of death the total loan balance is subtracted from the death benefit and the remainder of the funds goes to the beneficiary tax free.  So now we see how tax free income is possible, let’s take a closer look at the true benefits of these products.    

Policy owners in IUL products never lost a penny, even during the worst years of the recession, and have achieved moderate returns that have beaten any other fixed product available.  IUL policies are able to do this through a concept known as annual reset and interest crediting methods known as indexing.  Annual reset is a method that allows your cash value to reset each year regardless of how the market performs, while indexing allows you to accumulate interest based on the performance of an indexed fund, like the S & P 500.  When the market goes south you will simply break even; or in some policies earn a small rate of return, also known as a floor rate.  Conversely, when the market goes up you will receive a portion of the market upside; commonly referred to as a cap.  Investors are willing to trade all of the upside of the market in exchange for a financial product that will never lose a penny to market volatility with capped earnings.  I find it fitting to think of this as a batting average.  The analogy being that investors in these products are not trying to hit a home run, but instead are focusing on hitting singles and doubles; thus increasing their batting average.  The theory is, the more runners you get on base the greater chance you have to win the game.

As the financial crisis lingers on, IUL policies will be actively pursued by investors who are deemed insurable, or able to pass underwriting guidelines.  Truth be known, many corporations are now implementing IUL into their business practices in order to protect liquid assets and key employees.  This multibillion dollar industry could very well prove to be a multitrillion dollar industry over the next decade.  These policies will soon start to replace pretax deferred compensation plans that are completely taxable upon withdrawal, not to mention have severe restrictions on both what age you can withdrawal the funds at without penalty and restrictions on how much you are able to deposit each and every year.  Rest assured, investors that adopt income planning solutions to offset both future volatility and rising income taxes will be much more equipped to deal with an uncertain future.