Is Life Insurance King?

As we persist with historically low interest rates, market volatility, and massive federal deficit spending, will one financial asset stand out above the others?

Do we really think enough about taxes?

As a financial professional, I personally feel our industry has done an incomplete job at helping Americans reconcile the tax code for their benefit. Some of that is because the tax code itself is fairly complex and legislatively changing all the time. Most of it is due to regulations, where financial professionals who are not CPAs must keep tax conversations at a high level and avoid giving tax advice, and rightly so. However, I think our industry’s conversations about taxes has been a little “too light.” We have placed too much emphasis on “widely accepted savings advice,” encouraging consumers to save into traditional savings instruments while paying too little attention to the true cost of those vehicles overtime. I don’t think the advice that has been given is wrong, I think the conversations we have had are incomplete. We are not discussing all of the viable financial options available and we aren’t examining true tax cost and tax drag in one’s lifetime.

According to US Debt Clock our country is roughly $26 trillion dollars in debt. That is roughly $80,000 per citizen. That is a debt-to-GDP-ratio of roughly 136%. Even if these numbers are not entirely accurate, I don’t think there should be any question about what direction we think taxes may be going in the future. Of the three options for where taxes may be headed, down is clearly out. That leaves us with stay the same or go up. Based on those numbers, it is hard for me to make the financial argument that they can stay the same. This is not meant to be a political statement, but rather a math statement. If you believe that to be true, then the logical next question is, “what should we do about it?”

Challenging conventional wisdom

Maybe a good place to start answering that question is to examine how most Americans are currently handling the issue of taxes as it relates to the ways we save our money. If I asked 100 people “would you like to spend more in taxes or less,” I would guess that 99 would resoundingly respond “I absolutely want to pay less in taxes!” What vehicles are we taught to use to help reduce taxes? The largest two places Americas are urged to save money into are 401k’s (Qualified Employer Retirement Plans) and IRAs (Individual Retirement Accounts). The benefit of saving into these vehicles is that it helps reduce your taxable income in the year you make a contribution. I think many people hear this and logically conclude, “If I want to pay less taxes now, then saving money in this way appropriate.”

However, there may be a flaw in that equation we do not consider. In exchange for receiving a tax deduction today, the IRS allows Americas to defer (delay) having to pay taxes on those funds until retirement. But therein lies the flaw. If I think there is a significant chance taxes will go up, then are the chances high that I’ll end up paying more in taxes when I take the money out? Logically, the answer would be yes. Qualified accounts simply do two things: they defer the tax calculation and they defer the tax payment. If a 22% tax bracket in 2020 is an income threshold of $40,125 for a single payor and $80,250 for married couples filing jointly was increased by 20% to 26.4% at retirement, that would mean an increased tax payment of $1,765.50 for a single filer and $3,531 for married couples filing jointly a year. If you are retired for 25 years and these numbers stayed static, you would be paying an additional $44,137.50 as a single, and $88,275 if you’re married. Based on that simple hypothetical equation, using qualified accounts for the majority of our retirement savings might cost us more in the end than it saves. These numbers are magnified the higher up the tax brackets you go!

What’s the real rate of return?

Let’s go through some quick math to get you thinking. If you have 5 million in an IRA and you decide you’ll take a “safe withdrawal rate’ of 4% out to provide yourself with retirement income, producing $200,000 of income a year.  Now let’s say you have 3 million in a life insurance policy and decide to takeout $150,000 a year. That is $50,000 less in income each year. But because of the way the tax code treats distributions from a Life Insurance policy, that $150,000 is fully tax-free and does not generate a 1099, while the $200,000 would put you at roughly the 32% tax bracket (today) netting you $136,000 of income, and costing $64,000 in taxes. So the question is, what is the real rate of return when we actually factor in the reality of tax drag?

What’s the true value of an asset?

Most consumers look at a bank account or investment statement to see the total amount in the account and equate that to the value of that asset. And while no one can argue with that assessment, I encourage professionals to take things a step further and examine each asset based on how flexible it is and how it performs under stress. While watching a retirement account grow while you’re working can feel good, we all recognize that the majority of our retirement assets aren’t overly accessible (without penalty that is) until we reach retirement age. While their returns can be impressive, they do not offer a significant amount of access or flexibility. However, cash value life insurance can be extremely flexible, allowing for both withdrawals from the cash value, or policy loans over the life of the policy. In addition to your rainy day savings, often this may be the next easily accessible asset a client has, and important fact to emphasize, especially in light of the current pandemic when people might need more access to cash/capital and wat to avoid going into debt.

As most American’s stomachs turned when the market gave up over a trillion dollars in value earlier in the year, now is an excellent time to espouse the virtues of non-market assets such as cash value life insurance. Ask your clients, “How much value did your life insurance policy lose during the most recent market downturn?” While not nearly as sexy when the market is performing, Life insurance shines when the market “corrects” itself and can not only be a significant risk hedge, but also a psychological hedge for clients knowing you are using life insurance as a dependable financial anchor.

As study after study reveals Americans feel less and less financially secure as the pandemic goes on, now may be the ideal time to shift our conversations about saving and building wealth and place the well deserved spotlight on an asset that continues to stand the test of time.

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