Why tax-free income is vital for your clientsArticle added by Katherine Vessenes on December 5, 2012
Katherine Vessenes

Katherine Vessenes

Chanhassen, MN

Joined: August 21, 2010

My Company

Adding a new permanent insurance product to your suite of solutions could be great for your clients — and good for you, too. It sets you apart from the other advisors who are doing a straight AUM business, and it shows that you are different because you want to help clients reduce their income now and in the future.

Here is the number one question I get from advisors: How can I get in front of more clients and differentiate myself from other advisors?

The answer may surprise you. It is not about gathering more assets or doing a better investment plan. It is not about the latest asset allocation strategy, technical analysis or referral strategy. (Bear with me, I will get to the answer in just a minute.) Let’s shift gears just briefly. Here is the number one question we get from clients: Will I run out of money in retirement? In fact, the answer to the advisor’s biggest concern is also the answer to the investor’s biggest concern. And here it is:

A tax-free retirement

A dependable, predictable source of tax-free income in retirement. Who doesn’t like the sound of that? Picture yourself and your client sitting on an idyllic beach with a drink in hand. A feeling of peacefulness as the burden of the dreaded taxman is nowhere in site.

I predict tax-free income is going to be the future of our industry. Why do I believe this will be a growing trend? With the fiscal cliff looming and Taxmageddon around the corner, more and more people are getting concerned. But I believed taxes were going up long before the White House announced the most recent election was a mandate from the American People to increase taxes.
Here are a few of the reasons why I believe we will see a steady stream of tax increases:
  • Retiring baby boomers are creating a heavy drain on Social Security

  • Costly entitlement programs keep increasing benefits to larger numbers — some say as much as 50 percent of our U.S. budget is entitlement programs

  • Aging infrastructure requires tax dollars to fix our highways and bridges

  • True unemployment figures show that millions of Americans are both getting entitlements and not paying taxes, a double whammy for those who are paying taxes

  • Growing national debt, now in excess of $16 trillion, will require years of taxes to pay back the piper

  • Underfunded pensions mean tax payers will be bailing out both private and public pensions

  • Oh, and let’s not forget the new Obamacare taxes that go into effect in January, along with the elimination of the Bush tax cuts
And these are just a few reasons your clients will be facing more taxes in retirement! That’s why you need to take action today to help protect your clients. (And by the way — it will be good for your business, too.)

With taxes going up, it makes sense for financial advisors to focus on helping clients protect part of their retirement income with tax-free assets. Increased taxes and running out of money in retirement is definitely on the minds of your clients. I ask every client whether they believe taxes are going up or down in the future. With one exception, they have all said that taxes are going up. Clients are looking for advisors who are going to bring up these issues and provide them a solution for the future.
What does tax-free income do for your clients?
  • You are hedging the risk of increased income taxes eroding your client’s retirement.

  • You are providing a more predictable source of income for their retirement because your clients no longer have to worry about whether their 401(k) plan is going to be minimized due to higher taxes in the future.

  • You are providing an additional source of income that is not dependent on their pension, their 401(k), or Social Security.
How do we get tax-free retirement income for our clients? There are only three ways to get tax-free income:
    1. Muni bonds — As you know, if your clients purchase a state bond in their state of residence, then the interest is free of income tax at both the federal and state level. We rarely recommend these for a number of reasons: returns have been low and certain states — California and Rhode Island come to mind — have had numerous municipalities go bankrupt. For most of our clients, this is too much risk for too little return.

    2. Roth IRAs — If your married clients make less than $178,000 jointly and are less than 50, then they can do a direct Roth contribution of $5,500 in 2013. This is not usually enough to fund a tax-free retirement, unless their expenses are very low. It is a good place to start.

    For some of our clients, we use a “back door Roth” when they make over the income limits. This only works for clients who do not have an existing IRA. Here is how that works: Assuming they don’t have any funds in an existing deductible IRA, then we would create a brand new, non-deductible IRA. The client would fund it with after tax money. Then we would immediately convert it to a Roth. Since there is an immediate conversation and the funds have already been taxed, there is no tax on the conversion.

    3. Investment grade life insurance — Unfortunately, many comprehensive financial planners do not understand how important cash value life insurance can be to help clients retire with a reduced tax burden. Here is how it works: Over the last 15 years, the insurance companies have become much more savvy at looking at this product and the blessings Congress has bestowed on it.

    All permanent life insurance has a savings account feature that is called a cash value account. Congress, in infinite wisdom, has declared that the earnings in the cash value account grow tax-free and, if done properly, can be withdrawn tax free in the form of loans. With the right client, this can be significant income in retirement. How that savings account is invested depends on whether it is a whole life policy, universal life, indexed universal life or any of the many other variations. It is not unusual to get a 3 percent to 5 percent return on whole life policies or universal policies. Note: This is an after-tax return. So going forward, for your clients who are now in the highest tax bracket, this could equate to a 6 percent to 10 percent pre-tax return.
We usually recommend an indexed universal life policy for our clients. The returns there will vary from company to company, of course, but 8 percent to 9 percent, after tax, over the last 25 years is not unusual. Of course we never illustrate the returns at these levels, because we think the future is uncertain, and we want to be more conservative.

The amount of tax-free income from these policies can be substantial. Take this real life situation: With one of the carriers we use, a 35-year-old, healthy (standard) male, who invests $2,000 a month up to age 65, could enjoy an estimated tax free income of $188,000 every year from age 65 to 120!

We are always careful to explain how the product works, down-sides, the risks, surrender charges, expenses, and explain that these are estimates of what their income could be, not a guarantee.

So, here is your takeaway: Adding a new permanent insurance product to your suite of solutions could be great for your clients — and good for you, too. It sets you apart from the other advisors who are doing a straight AUM business, and it shows that you are different because you want to help clients reduce their income now and in the future.
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