Retirement means different things to different people. Some look forward to pursuing new interests, while others just want time to relax. Whatever the future holds, one thing is certain, a secure retirement requires careful planning. In this episode of Money Script Monday, Brian explains the benefits and considerations of using an Indexed Universal Life policy to generate tax-free retirement income.

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Video transcription

Hi, my name is Brian Manderscheid, and welcome to another episode of Money Script Monday. Today what I want to talk about is the rich person's Roth for a tax-free retirement income.

To start off, if you're like most of us, you understand that right now we have temporarily low-income tax brackets that are likely to be much higher in the future for a few different reasons.

Number one is we have until 2025, until the Trump tax plan expires. In 2026, we know that tax rate's going to be higher in the future.

Second, in addition to the Trump tax plan expiring, we also have mass amounts of government spending, government debt, entitlement programs, to worry about. And interest on the debt that's climbing day by day.

All these factors are likely leading to the fact that tax rates in the future are going to be higher. So rather than sitting on the sidelines waiting to be clobbered in the future by future income tax rates increasing, you can take a portion of either your income or assets and place it into an income tax free vehicle moving forward.

Today what I want to talk about are the four government approved tax free retirement vehicles, as well as dive in depth into the index universal life, which many refer to as the rich's person's Roth.

So, let's get into these government approved tax free retirement vehicles.

Tax-Free Retirement Vehicles

Number one is a Roth 401(k). Basically, this is 401(k) that is funded through after-tax contributions.

Rather than taking the upfront tax deduction, or tax postponement, you can pay taxes now while they're low and enjoy all the tax-free benefits moving forward.

If you're under the age of 50, the contribution limits are very favorable. You can fund up to $19,000. If you're over the age of 50, you can fund $25,000.

Keep in mind that these are the 2019 contribution limits.

However, the down side is limited availability. Most employers actually do not offer a Roth option, and they only offer the pretax option instead.

In addition to the employer availability, there's also limited access, especially while you're working. Typically, the only way to access funds from a Roth 401(k) is a loan which generally has very unfavorable provisions.

After the Roth 401(k), which again, we talked about may not be available, the next option is the Roth IRA.

This is essentially the bedrock of tax-free retirement vehicles.

Now, the contributions on a Roth IRA are significantly lower. If you're under the age of 50, you could only contribute $6,000 a year with a catchup provision if you're 50 and old, contribute $7,000, again, for 2019.

However, something to consider, is if you make too much income, you actually are forbidden from contributing to Roth IRA.

If you are filing single, you make over $135,000, you actually can't contribute to a Roth IRA. And if you're married, it's $203,000 is the limit for 2019.

So again, if you make too much money, this is not even an option.

In addition to the lack of the ability to contribute if you're a high-income earner, the amounts that you can contribute, the $6,000 and $7,000 aren't really enough to properly tax diversify for many individuals.

Those who want to fund $20,000, $30,000 a year, can't really do that within a Roth IRA.

Lastly, I want to point out to be aware of the five-year rule. Generally, distributions from a Roth IRA are tax-free if they're considered qualified by the IRS.

However, if you take gains from your Roth IRA within the first five years or pre-59 and a half, you can actually have taxes or penalties.

You can take out the direct contributions that you put in without taxes or penalties, but again, the gains are what you want to be concerned about.

Now there's another variation of the Roth IRA called a backdoor Roth IRA.

I mentioned that if you make too much money, you can't contribute to Roth IRA directly. However, you can through this backdoor approach.

The process is to make a non-deductible IRA contribution. The contribution limits are the same, the $6,000 and $7,000, and immediately convert that traditional IRA nondeductible to a Roth IRA.

Generally, that's going to be a tax-free Roth IRA conversion because of the fact that you're funding it with a nondeductible or after-tax funds.

However, the thing to be concerned about, to be aware of at least, is the fact that there's something called a pro-rata rule.

I mentioned that this is generally a tax-free Roth conversion. However, if you have existing pre-tax IRAs, there's actually a proportionate tax distribution on the amount that you convert, and now that you already have existing traditional IRAs.

It actually would cost income taxes to do a backdoor Roth IRA. So again, this may not be the option for you.

And lastly, we have the index universal life policy, which is known as the rich person's Roth.

Let's dive a little bit more in-depth on this policy. I want to be fair and talk about both the benefits as well as the considerations of the IUL, which again is known as the rich person's Roth.

Indexed Universal Life Benefits & Considerations

First, let's talk about some of the benefits.

I mentioned with all the other government approved tax-free retirement vehicles, there are contribution limits whether it's the $19,000, $25,000, or the $6,000 and $7,000 or the Roth IRA options.

There's an amount for the government that says you can't contribute over and above this.

With the IUL, there's actually no government contribution limits. You can fund as much as you want, of course, up to the insurance company's suitability guidelines.

This is a great option for those high-income earners, like yourself, that may want to contribute more than what you contribute in those other government approved vehicles.

You also have the upside of equity returns without the downside risk with principal protection.

Essentially the way the IUL works is you actually aren't directly invested in the stock market, but you receive index credits that's tied to a benchmark, that's something like the S&P 500, that could equity based, or bond based, or a combination of that.

You can earn the upside of that index up to a limiting factor, like a cap, just based on your spread, the tradeoff being is a 0% floor.

If the stock market goes down, you actually would receive a 0% and not lose any money.

You also have favorable access to cash value with participating loans, which are also referred to as index loans.

With this favorable access you can borrow from the insurance companies at very favorable rates. Some companies will guarantee a 5% maximum contractual rate that you can borrow from the insurance company at.

You're not actually distributing the money from your policy, you're loaning from the insurance company with your cash value and death benefit as collateral.

In addition to the low barrowing rate at 5% guaranteed for some companies, the loan amount you borrow continues to earn index returns on the policy.

The high likelihood is that it will earn at least 5%, if not greater than the borrowing cost. So, if you earn 6% or 7% on the amount we borrow, we'd actually experienced in that situation, positive arbitrage.

We've all heard the phrase "cash is king." I'd say it's actually liquidity is kind.

In periods of time where you need the money, the IUL policy is a great place to access liquidity.

We also have a competitive cost structure with an IUL, and I would say that over the course of your lifetime, the total policy costs will typically drain or drag about 75 basis points to a point and a half in total fee structure.

Now, obviously the younger you are, the healthier you are, the lower the fee structure, and the older you are, and the less healthy you are, the higher the fee structure.

It's important to point out that the majority of these fees go to providing the life insurance death benefit for your family or business.

Obviously, there are some fees to the insurance company and the acquisition, but again, a majority of the cost to go the death benefit for your family.

And lastly of course, the life insurance death benefit, which is really important if you were to prematurely pass away, there's a death benefit for your family.

Or in your retirement years, having a permanent life insurance death benefit to create a legacy while you're gone is crucially important.

While those are the benefits of the rich person's Roth, the IUL, let's talk about some of the considerations.

While you have unlimited amount of contribution limits, you can't fund in a single premium.

If you fund in a single premium, you create what's called a MEC, or a Modified Endowment Contract, where you lose some of the tax favored treatment on the distributions from the policy.

If you have a lump sum you want to contribute, you actually have to spread it out over roughly five years to get it in under the MEC so you're not losing all the tax favored treatment.

We also, as I mentioned, have limits on growth.

So, periods of time of bull market like we had in the 90s, or the rebound from the liquidity crisis where equity returns are 20-30%, we're going to have some sort of limiting factor, whether a cap, participation, or to spread, that's going to limit the amount of upside growth.

The tradeoff to that is the 0% floor, and if the stock market collapses, you would earn a 0 and not lose anything.

Additional consideration, a very important one in my opinion is the policy lapse, and surprise tax bill, if you over borrow from the policy.

I mentioned the mechanics to create tax-free retirement income stream from an IUL is to borrow from the insurance company at favorable rates with your life insurance cash value death benefit as collateral.

However, if you borrowed too much than the policy will support, and the loan balance exceeds the amount of equity, or cash value, you have in the policy, it could actually lapse, which would result in a phantom income tax bill that you would owe to the IRS.

There are riders and provisions in the policy that help prevent this, like over loan protection riders, but this still is a consideration that you don't want to take out too much money than the policy will support.

While the policy cost structure is competitive, the cost structure is heavily compressed and front loaded within roughly the first 5 or 10 years.

I would say that generally your crossover point is going to be within roughly five years or so where the cash value in the policy is greater or equal to what you put in.

Types of front-end policy costs that you'll see, you'll have a premium load. There'll be a charge based on the amount that you paid in the policy that comes right off the top if you're premium.

You also have expense charges that go to the policy acquisition that typically exists for 10 years, sometimes 12 years or longer.

I also put the admin cost as a concern. Now if you're funding $20, $30, $40,000 or more into a policy, and pay $5 or up to $10 a month for administration charges, that's not really significant.

But if let's say you're funding $100 a month, and have a $10 a month administration fee, 10% of your premium is going just to the administration of the policy.

So, I would say that would be cost prohibitive for funding that low of amount into this policy, and you may want to consider some of these other alternatives instead of the IUL.

Additionally, there's a cost bans, basically break points on the amount of death benefit you purchase.

We always want to buy the least amount of death benefit the IRS will allow. But the more death benefit you buy, the lower the cost of insurance per unit that you purchase.

If you're only funding a couple hundred dollars a month to an IUL, it may only buy a minimum death benefit of $100,000, and the cost of insurance per unit would be greater if let's say you're funding $20, $30, $40,000 a year, buying a million dollar minimum death benefit, you're actually buying more insurance, but the cost of insurance per unit is actually much less.

You actually get break points the higher death benefit you go.

And lastly, the other consideration is you need to qualify both health-wise and financially.

If you're an older individual with poor health, and can't qualify for life insurance, or you're going to be heavily rated, then this policy may not be the best thing for you, and you may want to consider some of these alternatives.

Additionally, you have to have a need for insurance.

If you don't have a need for insurance, you don't have a spouse, or kids, or businesses to support, debt to replace if you're to prematurely pass away, then this wouldn't be the policy for you. And again, you would have these alternatives to consider.

Summary

To summarize what we talked about today, we talked about the four government approved tax-free retirement vehicles to consider for a tax-free retirement.

We focused heavily on the rich person's Roth, which is the Index Universal Life policy.

As I mentioned at the beginning, we have this temporary window where taxes are on sale essentially.

We have a temporary income tax holiday through 2025 where we're going to be in a historically low tax rate. We understand 2026 moving forward, tax rates are likely to be higher.

You again, have the opportunity to either pay taxes on a portion of your income or assets now, place it into one of these government approved tax-free vehicles, or sit on the sidelines, and likely get clobbered down the road when tax rates are higher.

If you are considering a rich person's Roth, the Index Universal Life policy, it's also important to work with a qualified advisor to make sure these are set up correctly.

We always want to buy, again, the minimum death benefit that the IRS will allow, fund right up the MEC guidelines, but not above.

And also make sure that you're working with an independent agent who can pick the right Index Universal Life policy for you.

There are a lot of different carriers with different features and benefits out there in the marketplace today.

Again, working with an independent advisor allows you to comb the marketplace to find the absolute best policy for you.

With that folks, thank you for tuning. We'll see you next time.