by Neil Jesani
Background
To help understand the options presented in this chapter, it is first necessary to look at one of the newer regulations set out by the IRS. While reading IRS regulations is not anyone’s idea of fun, they allow you to see the logic of certain investments for your situation.
IRS Sec 7702 deals with the accumulation of life insurance policy cash value or account value. Prior to the writing of Section 7702, federal tax law took a fairly hands-off approach when it came to the taxation of life insurance policies. One could place an unlimited amount of money into a life insurance contract that offered a tax-free death benefit, tax-deferred growth of policy account value (interest and gains that build up within the policy were not included as part of the policyholder’s current income), and tax-free distribution of the cash value via a loan. This type of policy presented a problem to the IRS since people were using such life insurance vehicles to invest their money and take advantage of the generous tax breaks given to insurance policies.
Section 7702 was created to limit the tax benefits provided by life insurance policies. It did this by defining what would be considered a life insurance policy. Investment vehicles that didn’t fall under the insurance definition were not eligible for the favorable tax treatments. In short, it kept most of the tax benefits, but limited how much money you can stock into the life insurance policy. This does not, however, eliminate the use of whole life and universal life insurance as an alternative means to accumulate wealth and plan for retirement while reaping the favorable tax benefits life insurance enjoys.
Tax Treatment of Any Investments
Three tax benefits exist: 1) tax-deductible contributions, 2) tax-deferred growth, and 3) tax-free withdrawal of growth.
Most investments such as CDs, brokerage accounts, and savings accounts only enjoy one of these three tax benefits, and that is tax-free withdrawal of growth.
Traditional qualified plans such as IRA, 401K, 403b, SEP, Simple Plan, Profit Sharing and Defined Benefit Plans enjoy tax-deductible contributions and tax-deferred growth, but the 100% withdrawal will be taxed at the marginal income tax rate after the age of 59.5 of the investor. If taken before the age of 59.5, there will be an additional 10% excise penalty on the entire withdrawal.
The Roth IRA, the Roth 401K and a cash value life insurance policy (as governed by the IRS Sec 7702), enjoy the tax-deferred growth of the account value, and you can withdrawal the entire account tax-free. In the case of Roth plans, the withdrawal should be after the investor turns fifty-nine and a half or five years after starting the plan, whichever is later. For the cash value of a life insurance policy, no such restrictions exist and can be taken out any time.
Two specific investment vehicles – real estate and municipal bonds – are taxed a little bit differently. Real estate primarily allows tax-deferred growth and up to a certain dollar limit tax-free if it is the primary residence. Municipal bonds partially act like Roth plans and the cash value of life insurance policy. Earnings on municipal bonds are income tax free (only pay federal income tax unless the investor lives in the same state and/or city of the municipal bond), but the growth in the principal (if any) will be subject to capital gains if it is held more than a year, and ordinary income tax if held less than a year.
Traditional IRA/401K Vs. Roth IRA/401k
With a traditional IRA, 401K, and other defined contributions (Profit Sharing Plan and SEP) and defined benefits plans, you get a tax deduction up front. The taxes you pay on that income are delayed until you withdraw your money during retirement. Roth IRA, 401k, and the cash value of a life insurance policy, on the other hand, are funded with post-tax money, but the growth and withdrawal are tax-free.
So, the question is, which one is better? The answer is not simple, and it depends on many factors such as your current income tax bracket, net worth, other investment holdings, time to retire, and your ability to bite the bullet now or later.
“With a traditional IRA, you’re at the mercy or uncertainty of what future higher tax rates might do to your retirement savings,” according to IRA expert Ed Slott, founder of Ed Slott & Co. “With a Roth, you don’t have to worry about future rates, because your tax rate in retirement will be zero.”
Most expert financial planners/advisors agree that over the long term, a Roth IRA is better than a traditional IRA because it is better to be taxed on the “seed” money than the “harvest” money. Also, the current national debt of $22 trillion without unfunded liabilities such as Social Security, Medicare, and the budget deficit could be a danger to future tax rates.
Historically, we are now living in the lowest tax-rate environment. The average top marginal tax-rate since 1913 has been 58%. While the current national debt is $22 trillion, when you factor in the unfunded liabilities (following GAAP accounting standards, as most public companies do), then this number is above $100 trillion – almost $1 million of debt per tax-payer. Someday we will have to deal with this debt, and there are only two logical ways to do so: 1) Reduce spending and/or 2) Increase revenue.
Perhaps there is a sort of compromise. You can buy a cash value life insurance policy inside your traditional 401K defined contribution plan, such as a profit-sharing plan and a defined benefit plan. But keep in mind, as far as tax benefits are concerned, the traditional plan rules still supersede the life insurance tax benefits in terms of cash value withdrawal, but the death benefit is still income tax-free.
Rate of Return of Various Investments
There are two kinds of investments for wealth building: 1) Short-term and 2) Long-term.
The short-term wealth building investments are liquid assets, vehicles like checking accounts, savings accounts, money markets, and so forth, for your emergencies, opportunities, security, and overall peace of mind.
Before looking at the return of long-term savings and investments, let’s understand the underlying premise for all long-term investments and why you are giving up current enjoyment of your income. The goal is to have a comfortable income stream in retirement and pass the leftover assets to family and/or charities in the most efficient way. It only makes sense then to understand how retirement income streams work so that you can direct the savings you are accumulating today in ways that potentially give you the highest income when you retire.
In other words, the economics of how retirement income streams work define how you should allocate your savings today. The sooner you get on an efficient path, the greater impact you will have in terms of results.
Two rates make up everyone’s retirement income stream, and both are equally important. One is the accumulation rate – getting up the mountain. The other is the distribution rate – getting back down safely. Knowing how retirement income streams and distribution rates work is the basis for understanding how to save money in pre-retirement.
Accumulation Rate
In Chapter Five, I wrote about the three factors that affect your investment accumulation rate: 1) Asset allocation, 2) Taxation, and 3) Investment expenses.
There are three main asset classes for asset allocation: stocks, bonds, and cash. Three other asset classes have grown in popularity in the last few decades: real estate, commodities, and life insurance.
According to MeasuringWorth.com (a nonprofit organization advised by professors of top universities in the United States and Great Britain such as Harvard, Stanford, NYU, Vanderbilt, Oxford, and Northwestern), the annual growth rate of the Dow Jones Industrial Average (DJIA) since its inception on February 16, 1885 to February 28, 2019 is 5.14%. The annual growth rate of the S&P 500 since its inception on March 4, 1957 to February 28, 2019 is 6.92%, and of NASDAQ since its inception on February 5, 1971 to February 28, 2019 is 9.42%.
The following chart shows a comparison of the six main asset classes by the average long-term return, risk category, liquidity, and tax-efficient yield. The average expense ratio for actively managed mutual funds is between 0.5% and 1.0%, and typically goes no higher than 2.5%. For passive index funds, the typ
ical ratio is approximately 0.2%. Expenses can vary significantly between different types of funds. The category of investments, the strategy for investing, and the size of the fund can all affect the expense ratio. With an average expense ratio of 1.25%, large-cap funds are typically less expensive than small-cap funds, which average 1.40%. Life insurance involves two kinds of policies here – whole life and indexed universal life. Both provide fixed interest and no expenses for managing the investment, but you do pay mortality and other administrative expenses.
Asset Class
Long Term Return
Risk
Liquidity
Taxable or Tax-free
Stocks
7%
Very High
Very Low
Taxable
Bonds
4%
Low
Medium
Taxable
Real Estate
6%
High
Very Low
Taxable
Cash
2%
No Risk
Very High
Taxable
Commodities
6%
Very High
Very Low
Taxable
Whole Life Insurance
4.5%
Low
Medium
Tax-free
S&P Index Universal Life Insurance
6.86%
Low
Medium
Tax-free
Distribution Rate
Fidelity suggests limiting retirement income withdrawal or distribution at 4% to 5 % of your savings/investments. That recommendation is largely in line with the 4% rule, a withdrawal regimen that traces its origins to a 1994 study by now-retired financial planner William Bengen. Essentially, Bengen tested a variety of withdrawal rates using historical rates of returns for stocks and bonds. He found that 4% was the highest withdrawal rate (even though you can earn a higher accumulation rate) retirees could use if they wanted their money to last at least 30 years, assuming they invested in the most optimal portfolio of 50% bonds and 50% stocks.
In recent years, however, a number of experts have challenged this rule, warning that it no longer offers the same level of assurance against running through one’s assets than it did in the past. “The problem is that at today’s low-interest rates, bonds can not provide the same level of income they previously did,” says Wade Pfau, professor of retirement income at the American College of Financial Services, “That means investors have to rely more on the equity portion of their portfolio to support withdrawals.” Since stock returns are highly volatile, if you withdraw more than you earn in a particular year, you have killed a portion of your working principle that will no longer be available when the stock market goes up.
The Economic Power of Combining Two Rates
The first economic power to work with is the “Fluctuating Rates of Return” power, which can be a good accumulator of money. The second economic power is “Actuarial Science,” which also can be a good distribution of power. These powers were always meant to work together in proper balance.
If you don’t incorporate distribution power, then you can default to the 3-4% retirement income rate problem. When you incorporate Actuarial Science along the way, you put yourself on a path that can potentially provide higher retirement income rates from the assets you’ve built. The balance between these economic powers is the key. Having too much of either can make you less efficient. Then the power of actuarial science, through the death benefit and cash value of the whole life insurance or indexed universal life, can interact with the fluctuating interest rate power of retirement assets to create the ability to take higher retirement income rates safely. You need to be working towards building the proper balance between these two powers on your way to retirement.
At the time of retirement, you must choose these two cornerstones, which are called “Covered Assets” for the exchange/trade option and “Volatility Buffer” for the investment option. A covered retirement asset is accompanied by an equal amount of a whole life insurance death benefit. Similar to how most government entities provide retirement pensions to their employees, covered retirement assets lay the foundation for self-made pensions in retirement. This is accomplished through the interaction of a retirement income tool called an “Income Annuity,” which is a self-made pension, includes your whole life insurance death benefit, and is unrelated to the curves of the withdrawal rate simulations.
Under this option the interaction of your other retirement assets and cash value life insurance gives you the ability to create a guaranteed retirement paycheck for life. Historically this is in the range of 7% to 13% from the assets you’ve built, while at the same time providing perpetuation of retirement income for a spouse and/or a legacy for your heirs.
Over the past thirty years or so, the Internal Revenue Service has implemented various sections to their tax code to allow consumers to pick plans that work best for them. Section 7702 of the Internal Revenue code allows another option using the cash value of life insurance. Like a Roth IRA, there are no tax savings at the time of putting money into the plan, but there are advantages to the rest of the plan:
1. No income tax upon withdrawal from the 7702 plan.
2. No contribution limits to a 7702 plan.
3. No penalties for withdrawal either at the federal or state level before age 59½.
4. No required minimum distribution (RMD) at age 70½.
5. No stock market risks to the 7702 plan.
The key here is that the 7702 plan is based on the actuarial science power that uses whole life insurance and indexed universal life insurance. With whole life, earnings within the plan are based on fixed interest, dividends, and compounding interest. This is done without stock market risks through strong, highly rated life insurance companies that have been successful in business for over 150 years. I have written in detail about various cash value life insurance in Chapter 10: The Dull investment of Life Insurance.
Summary
Remember, you get one shot at setting up and establishing your retirement plan. The 7702 plan can give you a strong building block for your retirement foundation. If you are healthy, you can take advantage of this plan. You can meet your family obligations, and maintain your lifestyle when your working days are behind you. With the 7702 plan, you can do this with a peace of mind since you are saving on a tax-deferred basis, while earning powerful returns without market risks.
Also, a 7702 plan allows you more flexibility than many other retirement plans because there are no restrictions on when you access your money, and you can do so without paying income tax on it. When you are figuring out how to diversify your investments and savings, this should be a component worth considering.
CHAPTER 13
College Savings for an Expensive Education
“Wealth can only be accumulated by the earnings of industry and the savings of frugality.”
John Tyler
C
ollege is expensive. Not exactly a big secret there. The cost of a college education is constantly in the news. Its usual context is in how much money college graduates owe once they leave school and are out in the “real world.”
In its most recent survey of college pricing, the College Board reports that a “moderate” college budget for an in-state public college for the 2018–2019 academic year averaged $26,670. A moderate budget at a private college averaged $48,510. Of course, you multiply this figure by four and add some inflation to get an idea of the total cost for college. If your child goes to a school above the “moderate” figure, you are looking at even more money. Obviously, this is for undergraduate studies. If your child wants to get a graduate degree in, say, medicine, law or finance, you are looking at an additional $60,000 per year. If your child attends a four-year medical school, multiply the annual cost by four and add some inflation. You get the picture. It’s a serious endeavor for any family. At the same ti
me, an education from a top college can be the best possible investment you can ever make in your life, giving security for life to your next generation.
Since you are probably just catching your breath from the figures I mentioned above, I need to point out that they do not include room and board, books, supplies, transportation to campus and personal expenses. I didn’t want to shock you all at once. If current trends remain consistent, educational costs could potentially rise by 5% annually.
As a parent, you want the best for your children. You invest time into building your child’s character and integrity, instilling in them core values that will hopefully stay with them through life. Many parents believe that if they spend the time preparing their children to face the world, it will be enough to make them successful and happy in their life.
A major component in this day and age is that without a good college education, many of these intuitive, gifted young people will never fully reach their potential. Business leaders today place a large and unprecedented value on having a quality education from an esteemed college or university. Twenty years ago, having a college degree may have helped a person get a promotion. Now you need a degree just to get through the company’s front door.
Many parents today underestimate the huge financial commitment involved in financing a college education. It’s important to start effective college saving strategies as soon as possible. For this reason, it is vital to start planning for your child’s education when they are very young. A good rule of thumb might be to start during the time when each son or daughter (and if you’re a grandparent, when your grandchild) is a baby!