How Much Should I Convert?
As discussed earlier, it may be advantageous to leave some money in your tax-deferred bucket. Remember, you will still have your standard deduction in retirement. This will help you offset the distributions coming out of your tax-deferred account. If you have shifted all your IRAs to the tax-free bucket, you won’t be able to utilize your standard deduction. That means that you may have needlessly paid a tax in order to reposition these assets. You should strive to have an IRA balance large enough so that RMDs at 70½ are equal to your standard deduction.
Once you have determined the perfect amount of money to have in your IRA, you can then go about converting the rest of your tax-deferred assets. As a reminder, if you convert the money too quickly, that may bump you up into a higher tax rate, forcing you to pay more taxes than intended. If, on the other hand, you convert your money too slowly, you might not get all the heavy lifting done before tax rates really start to skyrocket. A good tax-free retirement specialist can lay out a strategy that will allow you to convert the right amounts of money, at the right time, while paying as little tax as possible.
*1 “Individual Retirement Arrangements (IRAs),” Department of the Treasury: Internal Revenue Service, publication 290, cat. no. 15160X, http://www.irs.gov/pub/irs-pdf/p590.pdf.
*2 Kelly Greene, “Nuts and Bolts of Five-Year Rule on Roth IRAs,” The Wall Street Journal, November 7, 2009, http://online.wsj.com/article/SB125754645803734655.html.
*3 “Individual Retirement Arrangements,” IRS, http://www.irs.gov/pub/irs-pdf/p590.pdf.
*4 William Perez, “The Tax Cost of Converting to a Roth,” About.com, March 19, 2012, http://taxes.about.com/od/retirementtaxes/a/Roth-IRA-Conversions_2.htm.
FIVE
THE LIRP
Notwithstanding your best efforts to reposition assets into tax-free accounts by traditional means, sometimes it’s just not enough. The tax-free alternatives that we’ve discussed up to this point have constraints and may only have limited impact on your efforts to get to the 0% tax bracket. To compensate for these limitations, it may be necessary to avail yourself of another tool in your efforts to achieve a tax-free retirement: the Life Insurance Retirement Plan (LIRP). The LIRP is an accumulation tool that shares many of the tax-free attributes of traditional retirement accounts such as the Roth IRA. Not only are distributions truly tax-free, but they also don’t contribute to the provisional income thresholds that trigger the taxation of Social Security benefits. The LIRP has additional characteristics that make it a surprisingly effective tool in helping you reach the 0% tax bracket in retirement.
A LIRP is essentially a life insurance policy that is specifically designed to maximize the accumulation of cash within the policy’s growth account. It accomplishes this by turning the traditional approach to life insurance on its ear. Conventional wisdom says that when purchasing life insurance, you should purchase as much insurance as you can for as little money as necessary. With a LIRP, you are buying as little insurance as is required by the IRS while stuffing as much money into it as the IRS allows. When utilized as a tax-free accumulation tool, the LIRP has a number of surprising benefits.
No Contribution Limits
As mentioned in the previous chapter, contributions to the Roth IRA are capped. If you’re younger than age 50, you can contribute as much as $5,500 per year (as of 2018). Once you turn 50, you can contribute up to $6,500 per year. If you find yourself in the position where your asset reposition strategy requires a shift that exceeds the allowable contributions to the Roth IRA, the LIRP can be very useful. The IRS poses no limitations on the amount of money that you can annually contribute. They only stipulate that the amount of your contributions be tied to a specific death benefit amount. Again, the key is to buy as little life insurance as is required by the IRS while maximizing contributions.
No Income Limits
If you find yourself hamstrung by the income limitations imposed by the Roth IRA and discover that your traditional IRAs make the nondeductible IRA option infeasible, the LIRP may be an attractive alternative. This is because the IRS poses no income limitations on LIRP contributions. It should come as no surprise, then, that about 85% of the CEOs of Fortune 500 companies utilize the LIRP as one of their primary retirement tools. In short, if you earn too much money or lack the necessary earned income to contribute to a Roth IRA (e.g., you’re retired), the LIRP can be a powerful alternative.
No Legislative Risk
Because tax-free accounts cost the government billions of dollars per year, they are an ever-growing target for revenue-hungry legislators. However, if history serves as a model, the LIRP will likely be immune from the impact of tax-law changes. When Congress changed the rules on LIRPs in 1982, 1984, and 1988, existing LIRP arrangements continued to be taxed under the old laws. In 2005, President Bush convened the President’s Advisory Panel on Federal Tax Reform in order to iron out the many inconsistencies and “loopholes” in the Federal Tax Code.*1 At that time, LIRPs came under intense scrutiny. Here is an excerpt from Chapter 6 of the panel’s report:
Some life insurance policies…allow for nearly unlimited tax-free savings…Under the Simplified Income Tax Plan, the increase in value in those policies would be treated as current income, and therefore would be subject to tax on an annual basis, just like a savings account.
At first glance, it seems like the death knell for LIRPs, right? A few paragraphs later, however, we get the grandfather clause:
Annuities, life insurance arrangements, and deferred compensation plans that currently are in existence would continue to be taxed under current-law rules.
Although the panel’s tax reform recommendations were never adopted, the above excerpt shows that there is a good chance that LIRPs already in place would survive similar legislative efforts in the future. Such grandfather clauses give the LIRP a much longer shelf life than traditional tax-free alternatives.
For example, if Congress were to act on legislation to eliminate the Roth IRA, you would likely be able to keep the money currently in your Roth IRA, but you would lose the ability to make further contributions. In contrast, the grandfather clauses that have historically affected the LIRP preserve the cash within the LIRP growth account and protect the ability to make ongoing contributions over the life of the program. This can be a very powerful way to protect your ability to contribute dollars to a tax-free account, regardless of congressional legislation.
Multiple Accumulation Strategies
In addition to its tax-free benefits, the LIRP provides a compelling array of options for growing dollars within the tax-free accumulation account. You are free to choose between one of three basic accumulation strategies at the outset of the program. Determining the right one for you will depend on your individual goals and objectives.
Insurance Company Investment Portfolio: You can opt to grow your money within the general investment portfolio of the insurance company that administers the program. Because insurance companies are in the business of managing risk, these types of returns tend to be conservative, but very consistent.
Stock Market: You can pass your contributions through insurance companies into mutual fund portfolios called sub-accounts. While this approach can provide much higher returns, it does expose you to the impact of severe market declines.
Index: You can contribute dollars to an accumulation account whose growth is linked to the upward movement of a stock market index like the S&P 500. You can participate in the growth of this index up to a cap, typically between 11% and 13%. On the flip side, if the index ever loses money, the account is credited zero, so that it never actually goes down in value. With back-tested historical returns between 7% and 9%, this can be a safe but productive way to accumulate tax-free dollars for retirement.
A Balanced Approach to Tax-Free Investing
To many, the LIRP
sounds like the perfect tax-free retirement tool. “Why not put all our money into the LIRP?” some might ask. For starters, it’s never a good idea to have all your eggs in one basket. Not only should you diversify your investments, you should also diversify your sources of tax-free income. Also, you have to remember that the LIRP is a life insurance policy. The IRS stipulates that, in exchange for nearly unlimited tax-free savings, you must be willing to pay for the cost of term life insurance out of your accumulation account on a monthly basis. Now, if you’ve already budgeted for the cost of term life insurance, it may make sense to recapture those premiums, divert them to the LIRP, and then take advantage of a huge bucket of tax-free dollars that wasn’t previously available to you.
In some cases, however, life insurance may not be at the top of your list. Perhaps your children have moved out and your house is paid off. Maybe your retirement accounts have accumulated to the point where you feel “self-insured.” The companies that sponsor LIRPs understand this and, in many cases, have done something to sweeten the pot.
Life Insurance as Long-Term Care: Doing Double Duty
Many life insurance companies offer a provision whereby clients can access death-benefit proceeds prior to death for the purpose of paying for long-term care. This is a compelling alternative to traditional long-term care insurance policies where clients pay premiums for protection which they hope to never use. When clients utilize the LIRP to cover long-term care risks, they still pay for it, but if they die never having needed it, their heirs still receive a tax-free death benefit.
At this point you may be thinking, That’s all well and good, but do I really need long-term care? Actually, long-term care is showing up on more and more people’s radars due to the impact that a long-term care event can have on a couple’s lifestyle in retirement. This may sound callous, but in some cases you’re actually better off financially to have a spouse die than to go into a nursing home. Let me illustrate with an example:
Let’s say that Mike Edwards has a $500,000 IRA, a pension that brings in $20,000 per year, and Social Security benefits that bring in $15,000 per year. His wife, Susan, was a stay-at-home mom and did the noble work of raising the children. As a result, she never got the chance to contribute to a retirement program. Mike reaches age 65 and has a stroke. He can no longer feed or transport himself and needs long-term care in a nursing home. Before Medicaid (the government’s medical assistance program) steps in to pay the bill, they will require Mike and Susan to go into “spend down.” This means that all the qualified assets in Mike’s name (in this case, his IRA) will have to be diverted to the long-term care facility to offset the cost of care. Further, a portion of the pension and Social Security benefits in Mike’s name will likewise be earmarked for the long-term care facility. Any jointly held assets will have to be spent down to $120,900 before Medicaid steps in to pay the bills.*2
After her husband’s stroke and transfer to a long-term care facility, Susan becomes what is called a “community spouse.” As such, Susan’s retirement accounts are protected from spend down.*3 The problem is, Susan doesn’t have any retirement accounts. You see, she was relying upon Mike’s IRA, pension, and Social Security benefits to support her in retirement.
Now let’s turn the tables. If Mike were to die, Susan would simply become the beneficiary of his pension, Social Security benefits, and $500,000 IRA. From a financial perspective, Mike’s death, while tragic, wouldn’t turn Susan’s financial world upside-down.
However, because Mike’s stroke necessitates long-term care, most of his assets risk being diverted to the long-term care facility. All that Susan gets to keep is one house, one car, the $120,900 of cash, and a Minimum Monthly Maintenance Needs Allowance (MMMNA).*4 Somehow I don’t think this is the type of retirement she was hoping for.
You can see how the absence of long-term care coverage can really upset one’s financial apple cart in retirement. The problem is, the traditional solution—long-term care insurance—can be costly and onerous. What’s worse is you could pay those premiums for 20 years and then die peacefully in your sleep never having needed them, and they won’t send you your money back.
In the case of the LIRP, your death benefit doubles as long-term care insurance. In the event that you do die peacefully in your sleep 20 years from now, never having needed long-term care, someone still gets a death benefit. So, there isn’t this sensation that you’re paying for something you hope you never have to use.
The True Costs of a LIRP
Because the LIRP can seem novel or unfamiliar, many thoughtful and proactive investors are researching it before incorporating it into a well-balanced, tax-free approach to retirement. In the course of their research, investors are invariably drawn to third-party critiques on the Internet offered by independent “financial gurus.” Curious about what was being written by these online opinion makers, I decided to make my own foray into cyberspace.
To my surprise, I found online assessments of the LIRP to be somewhat negative and largely uniform. In fact, if I could sum up the majority of their misgivings in one statement, it would be: “LIRPs have high fees!”
But do LIRPs really have high fees? If so, compared to what? To establish a baseline, I decided to look at the average fees for America’s most popular retirement account: the 401(k). According to USA Today, the total expenses for a typical 401(k) plan are about 1.5% of the entire account balance per year.*5 These fees go to pay record keepers, financial advisors, and mutual fund managers. In practical terms, this means that if your account’s growth were 8.5% in a given year, your statement would show a net growth of only 7%.
Now that we have a baseline, we can see how the average fees in a LIRP stack up by comparison. Generally speaking, the fees in a LIRP are higher in the early years and lower in the later years. Considered over the life of the program, however, these fees can average as little as 1.5%.*6
Like I mentioned earlier, the key to attaining this low level of expense lies in the proper structuring of the LIRP contract from the outset. To maximize cash accumulation and minimize expense, the contract must contain as little life insurance as possible while being funded at the highest level allowed under IRS guidelines. This “maximum-funding” scenario ensures that the level of expenses, as a percentage of the overall contributions, remains as low as possible.
The Economics of an ATM Machine
The best way to understand a properly structured LIRP contract is to consider an ATM machine. Whether you withdraw $20 or $200 from the ATM, your fee will always be roughly $2.50. If the fee never increases, then the very best value is to withdraw as much cash as the ATM machine allows. In a way, the same can be said of a LIRP. Whether you contribute the minimum required to keep the policy in force or the maximum allowed under IRS guidelines, your expenses won’t change. To achieve fees as low as 1.5% over time, the death benefit must be kept as low as possible while at the same time maximizing contributions.
The expenses you do pay, as I mentioned, go toward the cost of life insurance. So you are paying fees, but you’re getting something valuable in return: a tax-free life insurance death benefit when you die or a long-term care benefit during your lifetime. The moral of the story is this: Whatever road you take with your retirement accounts, someone’s going to be making roughly 1.5%. The question is, what are you getting in exchange for that 1.5%?
To focus solely upon the fees inside the LIRP, however, is to miss the broader picture. The real question that every potential LIRP owner should ask himself is, “Do the benefits of owning a LIRP outweigh the costs inherent to the investment?” Once again, a qualified tax-free retirement specialist can help you quantify the exact benefits of implementing a LIRP. If the math demonstrates that the LIRP can push you further ahead than where you would otherwise be, then it could be a welcome complement to your other tax-free streams of income in retirement.
“Why Haven’t I Heard of a
LIRP?”
Historically, the LIRP has been reserved for the wealthy segment of America’s population. As already mentioned, about 85% of the CEOs of Fortune 500 companies utilize LIRPs, as do quite a few members of Congress. In the past, LIRPs were weighed down by large expenses and provisions that made distributions difficult and costly. It was a great way to pass money tax-free to the next generation, but it was an inefficient retirement tool.
It wasn’t until recently that companies began to re-engineer these programs to mimic the Roth IRA. They knew that if they could structure the LIRP to capture the tax-free qualities of the Roth IRA in a low-cost way, they would benefit the everyday investor.
Tax-Free Bucket: The Ideal Balance
Now that we know that the LIRP and other tax-free alternatives exist, how much should you allocate to the tax-free bucket? To understand this, it’s useful to review the ideal balances for both the taxable and tax-deferred buckets. The taxable bucket should have roughly six months of income to protect against life’s unexpected emergencies. The balance in the tax-deferred bucket should be low enough that RMDs at age 70½ are equal to or less than your standard deduction for that year. Any dollar amount above and beyond the ideal balance in these first two buckets should be shifted to tax-free.
The Power of Zero, Revised and Updated Page 5