Every year, people look for ways to decrease their taxes. Life insurance and annuities are some of the best ways to do it.
From tax free withdrawals from a cash value life insurance to tax deferred growth with an annuity, both are tools available to limit your tax burden.
Let’s look at some of the advantages:
When you purchase a permanent life insurance policy, such as an IUL, some of the monthly premium goes to pay for the cost, charges and expenses the company has for the actual coverage. The remainder would go into a ‘side fund’, that grows according to an interest earned. This interest could be a fixed rate or a flexible rate that goes up or down according to the contract. If a flexible rate, the floor is usually 0%, and means that you may not earn any interest that year, and a ceiling of 10% or more.
So, for instance, if the premium was $100 using after tax dollars, the actual cost of insurance may be $60 which would leave $40 to go into an account that earns interest. Over the years, the value of the account will grow according to the interest earned and it does that in a tax deferred manner. This means that you won’t have to pay taxes on the gains like you would in other savings or investment accounts.
If the need arises, you can pull some of the money out of that account. It could be for a wedding for the kids, college, travel, or even to supplement your other retirement income. The best part of it is that you won’t have to pay taxes on what you take out.
Other than for retirement income, I would recommend “paying” yourself back by making payments to the policy like you would a bank. This will insure the policy will continue to grow and be able to help you reach your goals. It’s like a short term loan from the bank that you don’t have to qualify for or have a credit check.
Something else to consider is that the cost of insurance increases as you get older, so less of your premium is going into that account. However, with the 8th great wonder of the world, your account will be earning interest on the interest that it earned before! This is why it is vital that you start your non-traditional tax free retirement plan as young and early as possible.
How does this save me on my taxes now, you ask. By not paying taxes on the gains in the life insurance policy as you would in a traditional investment. This is also a way to allow you access to money tax free later, when the tax rate will probably be higher.
Now, let’s talk about an annuity:
When you purchase an annuity, it can be with a single ‘lump sum’ or multiple payments. Most are the lump sum variety. If you purchase this with pre tax dollars, it acts like an IRA, meaning that there are restrictions. Such as a penalty on money taken out before age 59 1/2 and you must take distributions by age 70 1/2.
With after taxed money, an annuity grows tax deferred and also allows compounding. Besides a decreasing surrender charge for early withdrawal, there are no other restrictions on when you can take money out. During the surrender period, the company will let you withdraw up to 10% each year with no penalties for emergencies or the what if’s in life.
In fact, some annuities even give you a bonus of up to 10% on the original deposit for agreeing to keep it for a certain number of years.
Another benefit with a Fixed Index Annuity is it allows you to take some of the risks off of the table. For instance, if you were to keep all of your money in the IRA/401k/investment, you could suffer a loss when the stock market drops. (depending on what accounts you are invested in, of course)
Like the life insurance policy, with the FIA annuity, there is a floor to your earnings or loss. That floor is usually 0%, meaning that if the market drops 10%, your account would not make anything that year, however, the important part is that you wouldn’t lose anything either. On the flip side, there is also a ceiling and if the market is up 20%, you may top out at 12-15%.
This is how the insurance company can afford to offer these great financial products. By limiting the gains, they can offset the losses.
So how does this help reduce my taxes? By not paying taxes on the gains each year as you would in other investments.
HERE is a brief description of how qualified and non qualified money is taxed.
You can also convert some or all of your retirement account into a Roth. This allows you tax deferred growth and tax free withdrawals but does have certain limitations as well.
The bottom line is this. If you want to have a tax break now, then put money into a qualified account, knowing that when you get ready to take distributions, you will pay the tax then. Or, use a non qualified account and get the tax break later. Both of these have certain risks involved by being in the market, but over time, can produce a nice little retirement egg. You can do a little of both, too.
My money is on the life insurance horse. I feel that taxes are going up to pay for our country’s significant debt and therefore, a tax free income is best.
If you want to cover all the bases, do all three! Allocate the maximum your budget can afford, take all matches available from work, and protect your family from financial ruin if something tragic should happen.