Retirement Planning: It's All About Taxes

Last week, during the AgencyONE Annual Advanced Markets & Underwriting Symposium, I had the privilege of listening to Jim Farmer from Financial Strategies Group present on Brackets, Buckets and Buffers. His presentation resonated so much with me that I had to write this article.

Jim is a brilliant planner and works with many high-income earners across the country in collaboration with financial advisors on retirement income planning. While I intuitively get the points he made and have spoken and written about them for many years, I spent some time this past week really digging into his message with the help of the AARP 1040 Tax Calculator, which Jim recommended.?This tool provides an easy-to-use template to help people understand their tax obligations based on certain income categories (ordinary income, dividends, capital gains, qualified plan distributions, social security, etc.)

As the old saying goes “it’s not what you make, it’s what you keep” and unfortunately, ignorance can be expensive when it comes to income tax planning for retirement.?

The idea is to set up three BUCKETS of money as you save money for retirement and of course, the sooner you start, meaning the younger you are, the easier it will be to fill up each bucket to the correct, or at least, the appropriate amount. The BRACKETS refer to the tax bracket you are in when you need to access the money, and the BUFFERS refer to various planning tools and products that are available to help guard against or lessen the likelihood of paying more versus less taxes.

The Tax Buckets

#1 The Taxable Bucket – most of us save for retirement in this bucket through our 401K, IRA, other qualified plans, and possibly into employer-sponsored, non-qualified deferred compensation plans. We make contributions on a pre-tax or tax-deductible basis, reducing our current income for tax purposes, and deferring the taxes owed until we withdraw the funds. These accounts are not taxed at all while they remain invested and growing. All distributions, however, both basis (amount contributed plus employer contributions, if any) plus accumulated earnings are considered ordinary taxable income in the year in which they are received. The ordinary income tax rate is different than the lower capital gains tax rate.

2024 Federal Income Tax rates and brackets are seen below:

#2 The Tax Deferred Bucket – those that have excess income beyond what is allowed to be put into qualified plans (there are limitations) will typically create non-qualified accounts. Here we will save at a bank (savings accounts or certificates of deposit) or buy mutual funds, electronically traded funds (ETF’s), stock, bonds, or other more esoteric assets. We may also buy homes, other real estate assets or maybe start a business. While these assets can generate ordinary taxable income during the accumulation phase, such as interest, dividends and short-term capital gains, these assets are typically taxed at long-term capital gains rates when they are sold.?

2024 Capital Gains income tax rates and brackets are seen below:

#3 The Tax-Free Bucket – finally, some people may choose to save money in tax-free offerings. Examples of these are Roth 401Ks, Roth IRAs, or cash value life insurance. Additionally, some retirees may invest in municipal bonds to generate tax-free income during retirement, but these are typically not used extensively during the accumulation phase. While investment contributions are made to these accounts with after-tax income, distributions are income and capital gains tax free, hence creating a tax-free retirement income bucket.

The Retirement Mistake

Most people fill up buckets #1 and #2 and disregard bucket #3. The reasons for this will vary, but essentially, they include the following:

1. They believe that taking a deduction today versus at some future point in time is more valuable thereby directing most, if not all, of their savings into a pre-tax 401K.
2. Their employer does not offer a Roth 401K alternative, or they are not aware of the benefits of a Roth option.
3. Their income may be too high to qualify for a Roth IRA in the absence of an employer offering.
4. Qualified retirement plans do not allow distributions prior to 59 ? without a penalty tax, so they invest in non-qualified bank savings or investment brokerage accounts for shorter term needs.
5. They believe that cash-value life insurance solutions are too expensive, do not provide sufficient liquidity, or are otherwise inefficient retirement savings solutions.
6. They are not properly educated on the differences between the various options available to them.

In the table below, I have created a fictional couple, both age 65, who have recently retired with enough savings to generate $126,000 per year of income, meeting their retirement income objectives. They are the typical 2 bucket couple with approximately $1,000,000 in IRAs and $1,000,000 in non-qualified accounts and using the 4% rule, distribute $40,000 from each. They also enjoy a combined $40,000 Social Security benefit, of which $34,000 is taxable, and $6,000 of interest income from checking\savings accounts at their bank. They take the standard deduction for their tax filing and enjoy a $32,300 reduction in income as a result. While they are in the 12% tax bracket on the IRS table, as you will see, they will only pay around $7,063 in taxes which puts them in a 5.89% effective tax bracket because of the standard deduction (taxes due of $7,063 divided by Adjusted Gross Income of $120,000).

Let’s assume, for a minute, that they had the foresight to accumulate $500,000 in a Roth and $500,000 in cash-value life insurance and were able to take $20,000 from each, instead of the $40,000 from a traditional IRA, effectively using the 3 buckets. You will see in the “3 Bucket Plan #1” column that their taxes drop to $1,343 or a 1.9% effective tax bracket. That is a $5,720 tax savings per year and $143,000 tax savings over their lifetime! It substantially lowers the taxes due on the Social Security benefits because Roth distributions and distributions from life insurance are not counted towards income for Social Security purposes.

Finally, the column showing “3 Bucket Plan #2” shows reallocating a portion of the assets into both Roth and cash value life insurance – taking more advantage of the tax-free bucket, while tax-optimizing their portfolio to take advantage of the lower capital gains tax structure. This can be an effective strategy, generating a result of $100,000 in tax savings over the couple’s lifetime.?

There is no right answer or combination to this planning strategy, and I am not suggesting for a minute that a traditional 401K plan should be ignored. There are a lot of benefits to pre-tax 401K contributions, including the very important employer matching contribution, but if a Roth option is available, it should be considered.

For those that are maximally funding their 401K options, pre-tax or Roth, or are not eligible for a Roth IRA due to their income, then a properly designed and administered cash value life insurance policy should be considered. While cash value life insurance can provide a variety of investment options just like any investment portfolio, it has two additional advantages over a Roth. The first is that it does not have a penalty tax for pre-59 ? distributions and the second is the obvious benefit multiplier at death. Furthermore, there are a variety of options in the market today that do not have the onerous surrender charges of traditional insurance products. Finally, there are a variety of supplemental "living" benefits, such as Long-Term Care, Chronic Illness and others that can be added to these policies.

I ran numerous scenarios using the above model and found that creating a plan that provides approximately 1/3 of the required income from each bucket provides meaningful tax savings to the traditional two-bucket scenario. Clearly, the higher the income requirements for retirement, the more dramatic the income tax savings due to the progressive nature of the federal income and capital gains tax structure.

One final comment is that the higher the income required during retirement, the more the Medicare tax emerges as an additional data point for consideration. By reducing taxable income, significant savings can be accomplished using the Tax-Free Bucket for Medicare planning purposes.

The key to the success of this planning is to start early. Time is your friend from a compounding standpoint and if permanent life insurance is part of the consideration, youth and health make planning much more effective.

For information about life insurance solutions or a customized analysis, please call the AgencyONE Marketing Department at 301.803.7500.