Maximizing retirement income with life insurance — the tax issues

By Steve Savant

Although I’m not a credentialed fiduciary, I am a keen observer of issues that affect how I address the insurance products I market. Taxation is a big one, expense loads a close second and proposal designs third.

In my storied 28-year career, I’ve had the privilege of conducting approved continuing professional education and continuing legal education for certified public accountants and attorneys. Although I’m not a credentialed fiduciary, I am a keen observer of issues that affect how I address the insurance products I market.

Taxation is a big one, expense loads a close second and proposal designs third. All of these items are hot button issues dear to the fiduciary market and should be to all purveyors of tax advantaged product lines.

Tax free municipal bonds — Tax free? Maybe not

Conventional tax free investing generally focuses around bonds issued by a city municipality or state government called municipal bonds or muni bonds. Each muni bond has some government tax exempt status attached to it.

Some muni bonds are exempt from city, state and federal taxation. The tax exempt status of muni bonds is very attractive for middle and upper class taxpaying citizens. Next to the tax exempt status of munis, bond holders look to third party, watchdog ratings services like Moody’s. (The bond’s beta risk is an additional consideration.)

Muni bonds may be used to fund tax exempt money market accounts, muni mutual funds and muni ETFs to spread risk via bond maturities and blended rates of return.

A few cautions: Some municipal bond income could be categorized as a tax preference item tax under the Internal Revenue Code. This could trigger the alternative minimum tax and can adversely cause Social Security benefits to be taxed. Few muni bond holders are aware that their muni bond income can fall into these indirect tax traps, the very reason they purchased muni bonds or muni funds — to avoid paying taxes.

More importantly, muni bond income is added to normal adjusted gross income to come up with modified AGI to determine how much Social Security income may be taxable.

Capital gain — 15 percent cap rate? Maybe not

The capital gains trap is another little known indirect tax on Social Security benefits. Capital gain taxes are significantly less than ordinary income taxes and therefore preferred by tax payers. However, while capital gains are taxed at a lower tax bracket, the full gain flows through the front page of the return and bulks up the AGI on the bottom of page one.
This can force the taxpayer into a higher income tax bracket for the rest of the income, and AGI is used to determine how much Social Security income is taxable. It also affects a non-tax item. It is used to determine Medicare premiums. That can add close to an additional $3,000 per year in premiums.

If all this wasn’t enough bad news, try to explain to a retiree why he or she is paying capital gains tax on a mutual fund that incurred losses. Again, the capital gains are added to the AGI. So, AGI already includes the full capital gains and then the IRS adds the muni bond interest to the formula.

Suddenly, these great tax breaks don’t look so good to retired people on a fixed income trying to live off their hard-earned nest egg.

The qualified retirement plan quandary propagates the theory that during your golden years, you’re in a lower tax bracket than your working years. There is a growing movement among economists that tax brackets will remain equal or experience an increase due to government deficits.

In this scenario, municipalities, state and federal governments will drastically cut spending, but in the end will have to raise taxes to balance their budgets.

This could have a huge impact on government-sanctioned, tax-deductible retirement programs. With the exception of employer matching contributions, the deductibility feature of qualified plans may be neutralized by equal or higher tax brackets at retirement. But even if your ordinary income tax bracket is lower when qualified plan income is distributed, it will be used to calculate whether you’re Social Security benefits are taxed as well.

(Caveat): A non-modified endowment life insurance contract kept in force for the life of the insured can generate tax free income via policy loans and/or withdrawals of basis.