Should you ignore history?
by Herbert K. Daroff, J.D., CFP, AEPMr. Daroff is affiliated with Baystate Financial Planning in Boston, Ma., and is a contributing editor to this magazine. Connect with him by e-mail: [email protected]
It is often said ‘those who fail to learn from history are doomed to repeat it’. Actually, the quote is, ‘Those who cannot remember the past are condemned to repeat it,’ by George Santayana.
How much did you pay for the first gallon of gasoline that you put in the car? What did you pay this week? How much did your last semester of college cost? What does your alma mater charge now? Does that mean that fuel prices and/or education expenses will continue to rise, at those rates? It does not, but what should your financial plan include for those expenses?
Gasoline prices may increase, but the engines are much more efficient, and many vehicles use energy sources other than gasoline. At older ages, you may drive less. Your financial plan needs to run “what if” scenarios so that you don’t sacrifice current standard of living because you are over-estimating the cost of your standard of living in the future. But, you also need to be careful not to under-estimate these costs during retirement.
The same is true for income tax rates. In 2018, the top federal income tax rate is 37%.
Do you think your retirement income will be subject to higher or lower income tax rates?
Even if you or your clients are in the 37% bracket, if most of their income satisfies the Qualified Business Income rule (QBI) and if they can take advantage of the 20% IRC Sec. 199A deduction for the pass-through business, then most of their income is in an effective 29.6% federal income tax bracket in 2018.
Should those clients fund traditional retirement accounts in 2018?
By now we all know that contributing pre-tax dollars that accumulate tax-deferred and are distributed as ordinary taxable income EQUAL contributing after-tax dollars that accumulate tax-deferred and are distributed tax-free, provided the tax rate during contribution equals the tax rate at distribution. However, if the tax rate at distribution is HIGHER than the tax rate at contribution, then Roth IRA, Roth 401(k), and Cash Value from Life Insurance produce a higher net after income tax result upon distribution vs. traditional retirement accounts. Traditional retirement savings is better only if the tax rate upon distribution is LOWER than the tax rate at contribution. That’s why you need to have both types of accounts, but not necessarily the same amount in each type of account.
If you or your clients are the owner of a pass-through business in 2018 and they are trying to reduce income in order to maximize the 20% QBI deduction, then qualified plans like defined benefit and cash balance may make sense even if they expect to be in HIGHER income tax brackets during distribution.
Many of us learned about a 3-legged stool as the model for retirement. It had three equal sized legs: one-third of your retirement income came from your employer provided pension plan; one-third from your Social Security; and one-third from your own savings. How’s that stool looking for you, today? And, there was no discussion about long-term care needs.
How does that old stool apply to you or your clients today. Very few of us benefit from a pension plan. Social Security may not account for a third of our retirement income. Most of our retirement income comes from our own savings, both qualified (e.g., 401(k)) and non-qualified.
A New 3-Legged Stool
Today, there is a new 3-legged stool; a financial security product that supplements your qualified and non-qualified accounts along with your Social Security. It offers: (1) income for retirement (or at any time); (2) long-term care coverage that keeps pace or exceeds the cost of providing custodial care at home or in a nursing home; and (3) income replacement for your survivors. It is available as a single pay modified endowment contract or as a multiple pay whole life insurance policy, that can have limited payments (e.g., 10 or 20 years, or to age 65).
On the multiple pay products, you can also have disability protection, creating an even stronger 4-legged stool for greater stability. The Universal Life model with long term care access provides a level death benefit and therefore a level long term care benefit. But, what has history taught us about the costs of custodial care? Will those costs continue to rise? We don’t know. Will life expectancy continue to increase? We don’t know that answer either. Risk management is all about planning for the unknown.
When clients talk to me about long term care planning, the first question I ask is, “Would you like that care provided at home, or in a nursing home?” How do you and your clients answer that question? All of the Elder Care Trust planning is designed to help circumvent the Medicaid rules, but only provides care in a nursing home. Long term care insurance, stand alone, or as part of a hybrid life insurance policy, or modified endowment contract, provides the funds for custodial care at home, or in a nursing home.
What have I learned from over 40 years of financial planning history is this: we have no idea what the future will look like. We need to plan for years when tax brackets are high, and low. We need to plan for years when investment markets are high, and low. We need to plan for dying too soon, as well as living too long.
I have never met a survivor who felt that the recently deceased has too much death benefit. Death benefit enables living insureds to dip further into their savings, knowing that the source of future income for their survivors will be replenished.
So, when you are thinking about buying a gift for your children and grandchildren, consider buying them financial security insurance:
- (1) a source of income for retirement (or at any time, including education, starting a business, etc.);
- (2) long-term care coverage that keeps pace or exceeds the cost of providing custodial care at home or in a nursing home;
- (3) income replacement for those who survive them; and
- (4) disability protection.
And, children and grandchildren, consider buying a gift for your parents and grandparents that also helps to protect you, your retirement, and your inheritance. ◊