The New Finance of Longevity

Shifting Brackets

Four tax-efficient strategies for retirement planning

by Steve Resch

Mr. Resch is VP of Retirement Strategies at Finance of America Reverse.

Understanding the potential tax implications on long-term investments is one of the most important considerations that financial advisors must be able to help their clients with when planning for retirement. Now, with tax rates at their lowest levels in modern history, it’s no surprise that one of the most common questions advisors are fielding is how to effectively prepare for an inevitable shift to a higher tax rate environment in the future.

Here are four unique tax-efficient strategies that individuals should consider today to help ensure that their investments go further in retirement tomorrow:

1. Roth IRAs

The Roth IRA is a retirement plan that is funded with after-tax dollars. This makes it one of the most tax-efficient ways to fund a retirement because all qualified distributions from a Roth are income-tax free. Roth IRAs are not subject to Required Minimum Distributions (RMDs), so there is greater control and flexibility over household income. Additionally, investments held within a Roth IRA can grow with no concern about capital gains or income tax liabilities, and distributions will have no impact on Social Security or Medicare brackets.

While tax-free contributions to Roth IRAs do have income limitations (with eligibility phased out based on your modified AGI and filing status), higher earners can take advantage of a Roth 401k, which has no earned income limitations, or a Roth Conversion. Because a Roth IRA conversion requires transferring pre-tax contributions from a 401K or similar retirement account to a post-tax Roth IRA account, it is a taxable event—so there are tax implications to consider first.

For example, a substantial conversion in one year could have the net effect of boosting taxable income by multiple brackets. Therefore, structuring a series of partial conversions over several years to keep the taxable distributions within a desired bracket may be an alternative. You can also help manage tax liabilities by converting more in years where you may have a lower income, such as early in retirement.

Beyond tax brackets, the other consideration is having the liquidity to pay the resulting tax bill from a conversion in a tax-efficient way, perhaps via discretionary income or other non-producing assets. However, if done properly, a Roth IRA conversion can provide exceptional tax efficiencies in retirement.

2. Life Insurance

A Life Insurance Retirement Plan (LIRP) provides another opportunity for tax-efficient retirement income. These are simply permanent life insurance policies whereby owners contribute extra money to build a cash value that is maximized for tax-free withdrawals in later years.

One of the key features of a LIRP is that unlike traditional retirement plans, it doesn’t require an annual income or have a contribution limit. This makes it an attractive option for higher earners who are already maximizing their 401ks and IRAs and need other options to satisfy their retirement income objectives.

Similar to a Roth IRA, there are no taxes on investment gains and withdrawals are tax-free. Also, unlike other retirement plans, withdrawals can be taken at any age, and there are no RMDs. Flexible investment options are available depending on the type of policy purchased, and most policies include an accelerated death benefit option to help manage expenses from terminal illnesses or physical incapacities. As this is a life insurance policy, there is also an income-tax free death benefit which is net of any loans or accelerated benefits that are taken out.

While tax-free contributions to Roth IRAs do have income limitations (with eligibility phased out based on your modified AGI and filing status), higher earners can take advantage of a Roth 401k, which has no earned income limitations, or a Roth Conversion...

LIRPs are complex products that, when structured properly, can provide a great opportunity for tax-free retirement income. They require a plan designed to ensure that investments during the accumulation phase, together with withdrawals and loans during the distribution phase, all stay within guidelines to maintain the LIRP’s favorable life insurance status. Be certain the financial professional you work with is well-versed in the intricacies of a LIRP.

3. Rental Properties and Vacation Homes

Another option that is often overlooked as a tax-efficient retirement income source are rental properties. Airbnb and Vrbo, among others, are online marketplaces that allow you to connect with people who are looking to rent homes or rooms on a short-term basis. For some retirees, a vacation home may have already been in the plans or part of their existing assets. For others, purchasing a second home in a vacation area or close to family may make sense and be worth considering as part of a retirement plan. Real estate can provide a revenue stream that is mostly sheltered from taxes due to deductible expenses and the depreciation allowed on investment properties.

Given the current market, there may be no better time to capitalize on the high demand for rental properties. More Americans vacationing domestically in home-like accommodations, combined with low financing costs, means there is the ability to lock in both a tax-friendly income stream and an asset with potential for long-term appreciation.

While the main consideration with second homes or rental properties may revolve around who will handle any issues that arise with the maintenance or renting of the property itself, management companies can take on some or all of the property management needs. This of course needs to be accounted for in the overall cost, but if the numbers make sense, rental properties can provide many years of tax-efficient income. In addition, as with any capital asset, rental properties pass on at a “stepped up” cost basis, minimizing any capital gains for your heirs.

4. Home Equity

Home equity can also be a unique source to help generate tax-friendly income for retirement. With interest rates at all-time lows, and home values at all-time highs, this could be an ideal point to refinance and leverage proceeds to fund some of the longer-term tax-saving strategies of a Roth Conversion, LIRP, or rental properties. For owners over 62 (over 60 in some states), they could also consider a reverse mortgage—not only to leverage their home for these opportunities, but also as an alternative source of income tax-free revenue for as long as they are living in their home.

Reverse mortgages no longer carry the negative “last resort” connotation of the past and are increasingly being utilized by more financially sophisticated borrowers for two simple reasons. First, all proceeds from a reverse mortgage are income tax-free, and second, there is never any principal or interest payment required for as long as the borrower is living in his or her home. Provided the homeowner maintains the requirements of a reverse mortgage—such as paying property taxes and homeowners insurance—this can provide reliable access to capital with no impact on household cash flow. Debt will accrue against the property if no payments are made, but the net value of including what is traditionally a dormant asset into a tax-efficient retirement strategy could have a substantial long-term income and legacy benefit.

In short, thanks to medical advances and a greater awareness of fitness, we should all be planning for a 100-year life. As our economy becomes more complex and indebted, a key consideration should be tax-efficient longevity planning designed to hedge against rising income tax rates.

Taking advantage of Roths, LIRPs and rental properties, while strategically using home equity, offers opportunities to diversify asset classes as well as tax exposure and can go a long way to help ensure a prosperous and efficient retirement income plan.