There are three things that are certain in life: Death, taxes and tax law changes.
In December of 2017 the Tax Cuts and Jobs Act (TCJA) was passed creating a limited window of opportunity to pay taxes now at possibly the lowest tax brackets of our lifetime. There were many significant changes to the individual income tax laws including reforms to itemized deductions and the alternative minimum tax, increased standard deductions and child tax credits, and lower marginal tax rates across all brackets. The intended results for the lower income tax rates for individuals and businesses was to spur economic growth and create new jobs. The unintended consequences may very likely be higher federal debt levels and higher future income tax rates—especially for higher income earners. As the law stands today the individual income tax reductions end December 31, 2025, and will sunset in 2026 to the pre-TCJA levels from 2017. This assumes of course another administration doesn’t impose legislation to repeal the TCJA and put in place a new set of tax laws.
So what does this mean for us?
Specifically addressing lower tax rates, this may cause traditional retirement accounts such as 401(k)s and IRAs to become less favorable. The reason being that 401(k)s and IRAs are specifically designed to defer income for today’s tax dollars with hopes of withdrawing contributions and gains at a lower tax rate in retirement. With a lower tax rate today the implied benefits of upfront tax savings would be reduced. For example, let’s assume a married couple 50 or older earning $200,000 and contributing $20,000 towards a 401(k). This couple would have been in the 28 percent tax bracket pre-TCJA and a 24 percent tax bracket currently. The impact is that the “tax savings” on the 401(k) contributions would reduce from $5,600 to $4,800—which is more than a 14 percent reduction. Something critical to point out is that in both situations we really aren’t saving taxes, but instead merely deferring taxes to a future date with an unknown tax rate. Essentially we are kicking the can into an unknown future where tax rates may in fact be higher.
With the tax rate drop and uncertain future tax rates, Andy Friedman of the Washington Update believes retirees should plan for something called “tax volatility.” Andy, a former tax attorney and current keynote speaker, stated investors “should maintain liquidity in both taxable and tax-deferred accounts and in tax-free investments. That way they can withdraw funds from one or the other depending on whether it makes sense to pay taxes that year (and if so whether to pay at ordinary income or capital gains rates).” Friedman adds, “Preparing for tax volatility allows an investor to take advantage of tax changes, whichever way they might go.”
Andy Friedman’s comments echoed what we at LifePro have been saying for years. Due to future tax rate uncertainty, our clients should add “tax diversification” to their overall comprehensive retirement plan by making sure they have an adequate mix of dollars inside their taxable, tax deferred and tax free buckets. Make sure clients are properly diversified in various asset classes (stocks, bonds, real estate, annuities, life insurance, etc.). Why not take the added step to also diversify tax types? Financial experts across the country are making similar statements—the TCJA could mean vehicles like Roth IRAs, Roth 401(k)s and indexed universal life may be more appropriate for some investors.
What do industry experts anticipate?
Experts are saying the income tax deduction from a 401(k), or traditional IRA, provides less value in a low tax rate environment, particularly when the deferred income may be taxed at higher future tax rates. While we can’t be certain tax rates in the future will be higher, we can look at data from the best and brightest who believe we as a nation are on an unsustainable path with trillions of dollars in debt coupled with trillions in unfunded future liabilities.
Another popular keynote speaker, David Walker, former Comptroller General of the US and head of the GAO for a decade, stated government debt “is not just a financial issue. This is not just an economic issue. This an ethical and a moral issue. We are mortgaging the future of our kids and grandkids at record rates.” Walker, essentially the top accountant for the US Government, has intimate knowledge of our government’s spending, budget and debt. In fact, he once said “we are heading to a future where the U.S. Government will be forced to either cut spending by 60 percent or double federal tax rates.” Regardless of what the current or future administrations propose, they are all inheriting the same math problem in which there are limited solutions: Spend less, increases taxes, or some combination thereof.
What can we do as advisors?
First, we must educate our clients about the importance of tax diversification by making sure we are not neglecting the tax free bucket. We can start to fill up the tax free bucket either by converting existing IRA assets towards Roth, contributing to a Roth IRA or Roth 401(k), or funding an indexed universal life policy. There isn’t a clear one-size-fits-all plan and it depends on each client’s individual financial situation. Clients who are heavy in traditional IRAs and have adequate cash accounts to pay the tax bill may benefit the most from strategic Roth IRA conversions over the next seven years during the TCJA lower tax rate window. One popular strategy is to convert up to the room left in your current marginal bracket. For example, a married couple with a $50,000 AGI can convert almost $29,000 and stay within the 12 percent bracket without jumping up to the 22 percent bracket. For clients who haven’t yet accumulated a significant pre-tax retirement account balance, or have limited cash accounts but have the ability to redirect cash flow, may be better off contributing to a Roth IRA, Roth 401(k) or indexed universal life.
Of course there are income phase outs on a Roth IRA and contribution limits on both the Roth IRA and Roth 401(k). Indexed universal life combines the tax deferred growth and tax free access of cash value with an income tax free life insurance death benefit. Additionally, the cash value growth is not directly invested in the stock market. Instead the growth is based on the price change of an external index, such as the S&P 500, with a limiting factor such as a cap or participation rate. The trade off on the upside limit is a zero percent annual floor protecting the cash value from negative market performance.
As for funding indexed universal life we always want to make sure to buy the absolute minimum death benefit the IRS will allow and fund up to the Internal Revenue Code guidelines. By doing so we can minimize the mortality expenses, which in turn will maximize cash value growth potential. A common structure is to design the IUL policy with the minimum increasing death benefit with a seven year or greater funding period, paying up to the maximum premium limit and switch the death benefit to level once the client is permanently done funding. We call this a “long pay” design as the client has the ability to fund premiums for a longer period of time. We generally use a long pay design for cash flow funded cases where we want the flexibility of being able to choose how long we want to fund. A second common structure is to design the IUL policy with the minimum level death benefit and fund up to the seven-pay premium until we fill up the Guideline Single Premium (GSP), which generally takes about five years depending on the age, gender and risk of the insured. Additionally, with this strategy we can reduce the death benefit down to the minimum cash value corridor after the cumulative Guideline Level Premium (GLP) crosses over the Guideline Single Premium (GSP). We can also use a “short pay” design since our goal is to fund the policy as quickly as possible. We generally use a short pay design for asset funded cases where the client has existing assets and wants to fund those into an indexed universal life policy for the tax favored treatment and competitive returns while eliminating the downside market exposure.
While the TCJA has reduced individual income tax rates for the next seven years, we must look at the bigger picture. Just like a client who is stuck in the repetitive debt cycle, we as a country must first come to terms with our current situation and then act decisively. As advisors we also share some of this burden. It is not just our job, but it should be our mission, to help educate our clients and prospects on the importance of tax volatility and tax diversification. Just like David Walker, we believe we have an ethical and moral obligation to share this information with as many people as possible in hopes that we can help lead them down the right path. More than ever our clients are looking for certainty, clarity and confidence in these uncertain times—which only you can provide.