Getting Back To Even

Getting Back To Even

Among the problems people face, paying too much in tax is not really a bad one.  As I like to say, it certainly beats the opposite problem, paying too little as a result of having too little income!  Given the time of year, however, the issue of increased taxes is more than likely front and center for most clients, particularly for the wealthy who are still growing accustomed to the new rates.

Now, a quarter into the year, just when they are starting to settle in, for those clients reaching 70 and a half this year, things are going to get ugly again.

Required minimum distributions

While being forced to take income you don’t need or want certainly falls into the category of a good problem to have, it is a problem nonetheless.  Further, the increased tax rates that high net worth, high income clients are facing makes this issue all the more painful in 2013.  Not only do these clients have to take the income, they now see less of it stay in their pocket.  Admittedly, this problem is not new in 2013, but the increased tax impact opens doors for us in the planning arena that may have been closed previously.

Here’s why: the larger tax bite erodes the value of qualified plan assets.

Based on a whole pile of data, most of the population does not want to get back into the market and are going to have to find a place to put that money once distributed.  If not positioned in the market, then the RMD amounts may be doomed to what is essentially being stuffed under the mattress from a rate of return standpoint.

Rather than focusing on maximizing the qualified plan, I think, in this market, it’s more about getting back to even.  How large a mountain does the client’s RMD need to climb to get back to even?  Based on a few different marginal tax rates and rates of return, it could be as long as sixteen years.

Remember, these assets are now in a completely taxable environment, so any rate of return assumptions are net after tax.  Sixteen years is a long time to recover the amount lost to taxes, so what is this client left to do?

How life insurance can help

Given that we are in the life insurance business, you can probably guess that both solutions are a life product.  For reasons that we should be able to rattle off at a moment’s notice, life insurance is uniquely positioned to solve this problem.  There are a couple ways to approach the sale, however, depending upon what is truly important to your client.  They both involve the death benefit as the mechanism for making the client whole.

Remember, they do not need the money, so buying a commoditized death benefit only type product works just fine here.  That product can also provide the peace of mind that comes with guaranteed death benefits – although that is not as true as once thought.

If that is the chosen route, a 70-year-old couple with standard health and a $50K net after tax distribution can buy a policy with a face amount of over $2.2MM and call it a day.  There is the issue, however, of recouping amounts lost to taxes while they are still enjoying their golden years, and that is where we may need to rethink how to execute a life insurance solution.  Let’s recover the taxes via the death benefit, but not at the expense of accumulating some cash along the way.  Rather than maximize the death benefit, a design that balances the face amount with cash accumulation goes a long way here.

I’m not saying that we are going to use this policy as a source of income, however.  Rather, I think the cash value looks great on the client’s balance sheet if we look back at the motivation: getting back to even.  The cash is there if they need it.  Check out this example.

Remember, life insurance is the only self-completing approach to this, just in case the client doesn’t have 16 or more years to let the asset grow.

At the end of the day, maybe it makes sense to take a look at those tax returns, with a particular focus on clients taking RMD’s and then listen for comments about paying too much in tax.  Clearly, that client is ready to have the conversation about getting back to even.

Pay Less, Get More The Retirement Gap