How Life Insurance May Protect Your Retirement from Future Higher Taxes
This video explores how the tax sanctuary of life insurance can help protect your other investments against the threat of future higher taxes.
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A century of marginal tax brackets
There is no bracket called “retiree”
What the TCJA discount is worth
Toggling your bracket in retirement
There are two certainties in life — death and taxes. Instead of talking about death, let’s talk about how a properly structured life insurance policy can help you during your lifetime: navigating, toggling and buffering against volatile changes in the tax code that might otherwise be very detrimental to your retirement distribution strategy.
A Century of U.S. Marginal Tax Brackets, Top and Bottom
We pulled the historical marginal tax brackets straight off the IRS website and plotted two things year by year: the highest marginal rate in effect, next to the lowest marginal rate in effect.
The income tax started as a temporary tax right before World War I. (I’m sure they’re about to repeal it any day now.) The highest rates spiked dramatically during the war, and the lowest rates spiked dramatically too in percentage terms.
Once the catastrophe was averted, rates came back down at the top and at the bottom. Then coming out of the Great Depression they went up higher again — top and bottom both — and stayed high for quite a long time. They only started coming down again to the lowest levels since the Roaring 20s when Reagan took office and proposed the closest thing to a flat tax we’ve had.
Why the Top Brackets Move Harder Than the Bottom Ones
The convergence between the highest and lowest brackets is about as close as it has ever been. Most of you remember the fluctuations along the way — the top rate moving between 28% and 37% through the Tax Cuts and Jobs Act.
What I want you to focus on is that the two tend to move in tandem. When one goes up, so does the other. When one goes down, so does the other. But the higher brackets tend to be a lot more penal — their movements are far more exaggerated than the movements in the lower brackets.
That’s the whole point here: life insurance can let you toggle or buffer against those more penal brackets by structuring your assets now, so that you undoubtedly still own some things that are taxable, but you’ve also built a bucket that’s exempt from taxes and can help you avoid the exaggerated high-end brackets in retirement.
There Is No Tax Bracket Called “Retiree”
Put the old brackets next to the new ones, focused on married filing jointly (the individual brackets tell the same story). Notice what isn’t there: a bracket called retiree.
People assume they’re going to be in a lower tax bracket in retirement. I shouldn’t say erroneously, because some people will be — but it can be challenging. The kids have grown up. Business owners no longer have all the generous deductions they were running through the business. The house might be paid off.
So when I ask people how they heard they were going to be in a lower bracket in retirement, they’ll often say “from the media, or from my accountant.” Then I’ll ask whether they can get that in writing. Obviously the answer is “no.”
Meanwhile I can think of about twenty-one trillion reasons why the tax brackets as we know them will have to go up, whether you’re retired or not. I get concerned when people simply assume their bracket will be lower. The good news is there are strategies to protect against that — or to help create that situation for yourself.
The Discount the Tax Cuts and Jobs Act Handed You
The biggest opportunity is that everybody got a break under the Tax Cuts and Jobs Act. Compare the newer rates against the old ones and it’s clear where the discount sits.
The old 15% bracket went down to 12% for the exact same thresholds. The 22% band running from 77 to 165 is three percent off the old 25% bracket — and you get that discount for an additional nine grand of income on top. From 165 up to 315 is where it really shows: we used to pay 28% from 156 to 237, and that old band effectively gets cut in half, with four percent off on the lower portion and as much as nine percent off by the time you reach 315.
I realize some of you lost the deductibility of state and local taxes, as I did. But if you’re a business owner, what you picked up was 20% off all of your K-1 income — and that includes Schedule C earners.
There’s a limitation if you make over three hundred and fifteen thousand and you’re a service-business professional like me. Stay under that and it doesn’t matter whether you are or not: if it flows through to your K-1, you don’t pay tax on 20% of it, which is quite amazing.
To make that concrete for the independent contractors and service businesses taking K-1 income: say you’re married filing jointly, you made two hundred and fifty thousand dollars, and all of it was Schedule C or K-1 income. Twenty percent of two-fifty is fifty thousand dollars. Subtract that, and you pay tax as though you earned two hundred thousand, even though you earned two hundred and fifty.
Pay Your Taxes While They’re On Sale
What I’m suggesting is that you use some of those tax savings rather than deferring them — because you may well be sitting in the lowest tax brackets you’ll ever be in for the rest of your life. Your taxes are on sale.
Rather than defer all of it, maybe it’s time to pump the brakes on the 401(k) and the SEP, take some of that money, pay the tax while it’s cheap, and put it into something that will be tax-exempt in the future. Something like permanent life insurance — whether that’s whole life or indexed universal life — built to generate good retirement income at a risk profile you’re comfortable with.
What Happens When the Brackets Go Back Up
When the next set of brackets arrives — the ones that aren’t here yet — even a switch back to the old brackets would be enough to make the point. You wouldn’t be in a lower bracket. You’d be in a higher one.
And that’s before you consider what happens if the government decides it needs to start paying down twenty-one trillion dollars of debt and everything moves up by ten points — not even counting your state. If the brackets change and go against you, you’ve still got a move: supplement your income with money coming out of the life insurance while pulling only what you want from the qualified plans in the lower brackets.
Toggling Your Tax Bracket in Retirement
Suppose the lower brackets go up a little and the upper brackets go up a lot. Here’s how you work that.
You have income sources that are fully taxable — the qualified plans you deferred into, Social Security that may be partially or fully taxed, rental real estate whose depreciation has run out, plus your stocks, bonds, dividends and mutual funds. You control how much you pull out of the qualified plans, which means you control how much of your income lands in the penal brackets.
Everything above that line, where you’d otherwise be paying a lot of tax, you replace with tax-exempt income from the life insurance. So if you want to live a particular lifestyle but only be taxed on a smaller one — so be it. Life insurance is what lets you toggle.
A Tax Spike May Be Temporary — Borrow Through It
A spike may also be temporary. History shows plenty of prior spikes, so if a big one hits, you delay again. Pump the brakes on the 401(k) and pull aggressively from the life insurance policy instead — which assumes you funded it aggressively during your working years.
You can withdraw from a policy, or you can borrow against it. A high-tax stretch is exactly the reason to borrow aggressively from your life insurance for income during that period and take only a trickle out of the 401(k) to stay inside the lower bracket.
Then when tax rates come back down — they normalize, a new regime gets into office — you pull from the 401(k) to make your life insurance policy whole again.
Retirement Isn’t Linear, and Neither Are Taxes
This is hard for people, because we naturally want things to be linear. We want a retirement plan that runs in a straight line. It doesn’t — not in market movements, and not in taxes.
That’s the whole purpose here: to show you it isn’t as linear as you would have liked to plan for, but there are things you can do now, using life insurance as a buffer, so you have a supplemental bucket to pull from and can better control your tax bracket during retirement.
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John “Hutch” Hutchinson has no affiliation or association with The Infinite Banking Concept®, The Infinite Banking Institute, or Nelson Nash, nor his book Becoming Your Own Banker – Unlocking the Infinite Banking Concept; nor with Bank on Yourself, Pamela Yellen, or her book The Bank on Yourself Revolution. “The Infinite Banking Concept®” is a registered trademark of Infinite Banking Concepts Inc. “Bank On Yourself®” is a registered trademark of Hayward-Yellen 100 Limited Partnership.