Getting Tax Efficient

by Craig Moser on November 30, 2018

I frequently see people losing money to taxes.  Usually it’s because they don’t consider (or understand) the impact different types of investments have on taxes.  The trade-off of getting tax efficient is accepting short-term costs for long-term benefits.  Below are some examples of common investments and how they impact your tax situation.

Roth IRAs

Taxes have already been paid on money in these accounts.  This means your money grows tax-free (through compounding and/or gains).  When you make a withdrawal for various needs (retirement), the distributions are free from all future taxes.  Also, these distributions don’t cause things like social security, dividends, capital gains, etc. to be taxed.  A big impact.

Predictably though, Roth IRAs only allow you to deposit $6,500 per year if you are older than 50.  To add insult to injury, if you earn more than $199,000, you phased out on that contribution.

Roth IRA Conversions

You can move money from IRAs and 401ks.  However, you didn’t pay taxes on the money deposited into these accounts.  Therefore, when you convert an IRA or 401k to a Roth IRA, taxes are due.  In short, you pay taxes using tax bracket you find yourself in, plus taxes from the conversion, will be paid in the year of the conversion.

One thing to understand is you eventually pay taxes no matter the investment type.  It’s basically a decision of “pay me now or pay me later” on your tax hit.  Despite this, once funds are converted to the Roth, they are no longer subject to future taxes.

If you’re younger than 59 ½, it’s also important to know there is a 10% penalty when you withdraw converted amounts that were taxable within five years of the conversion.

Properly Structured Cash Value Life Insurance

Here you buy either a whole life or universal life insurance policy with a cash value account.  Instead of paying the minimum premium cost, you fund as much money into the contract as the IRS will allow.  This allows money in the cash value to be accessed tax-free in the future.

In these strategies, you have access to your money either through withdrawals (First In –First Out) or through policy loans (which allow you to have control on when you repay the loan).  However, both guarantee you can access a loan, and leave your actual money compounding while you borrow from the insurance company.

On a personal note, I sometimes use mine to borrow and buy real estate.  Then I sell the real estate for a profit and repay the loan.  This way I don’t lose the compounding, and I don’t begin a repayment schedule which reduces my cash flow.

So, you can fund a much higher level of money into the accounts, avoid current taxation, have a collateral account, and have access to the death benefit (prior to passing away) for either a terminal illness or for Long Term care needs.

Tax-Deferred Annuity

You can deposit money into a tax-deferred account which avoids current taxation and can be invested in any of 3 ways.  You can have a daily compounded rate of return (currently around 3.8%), have mutual funds like a 401K would typically have, or use an indexing strategy which would give you some or all of an indexes’ returns if they are positive while avoiding the losses if they occur.

Using after-tax money allows you to avoid taxes while funds are invested.  When you withdraw money, you pay taxes, at current income tax rates, on the gain.  Once you reach the original principal value, you simply have a return of your deposit without taxes.  There are a few programs available which give you the ability to take some of your principal and some of your gain systematically while maintaining liquidity.  Additionally, if needed in the future, you can add a rider guaranteeing a tax-efficient income for life.  In this scenario, you still have any remaining account values pass to your heirs in a more tax efficient manner than most “basic” annuities.

We work with strategies like this all the time.  If you’re open to listening to tax avoidance strategies, we can work together to see if there are options that fit you and your lifestyle.  Feel free to give us a call at 336-448-1086 to schedule your complimentary, no-obligation discussion.

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