Like it or not, taxes are the single greatest enemy of wealth accumulation.
The number of taxes we pay in this country is mind-boggling. The government has its hands in every single one of our pockets and is constantly reaching for more! We have federal income tax, state income tax, sales tax, property tax, payroll tax, estate tax, excise tax, corporate tax (it just gets passed on to you), Social Security tax, Medicare tax, gas tax, hotel tax, airline tax, and in some places even tax on groceries! Had enough yet? We're taxed when we earn, taxed when we spend, taxed when we save, taxed when we invest, and taxed when we die.
So, one should take advantage of the legal tax-minimizing strategies that are available to us. One such strategy is a Roth IRA. This type of IRA offers tax-free accumulation and distributions because taxes are paid before contributions are made to the account. As Kyle mentioned last month, this contrasts with a traditional IRA which is funded with pre-tax dollars but taxed when money is withdrawn. Sadly, however, the ability to fund a Roth IRA phases out at higher levels of income. Thankfully, there is a lesser-known strategy we’ll call the Rich Person’s Roth which may be the key to unlocking more tax-free income in retirement.
If you are maxing out your retirement plan contributions and still have excess income you are not using for living expenses, this strategy may make sense for you. You may be asking yourself (and if you are not, you should be) “Where else can I put money that can compound for years and either postpone or completely eliminate taxes?” One such place is a specially designed form of life insurance contract. Decades ago, life insurance was granted favorable tax treatment, meaning that growth of assets inside a permanent life insurance policy is tax-deferred and distributions of assets during the lifetime of the insured can be tax-free (the death benefit is also tax free in the vast majority of situations). There are nuances to this strategy that apply in certain situations that I won’t detail here as they are very much exceptions to the rule, but adding permanent life insurance to your balance sheet may be worth considering. This strategy, sometimes referred to as the Rich Person’s Roth, can offer as much, or as little, tax-free income in retirement as you are willing to plan and save for. As the name implies, this strategy has many of the benefits of a Roth without the income limitations that prevent high earners from participating. Please note the type of policy used, and its design and structure, does make a critical difference in the success of the strategy. Just any permanent policy from any carrier willing to insure you is not what I’m referring to here.
Source: Forbes
Now, before declaring that Suze Orman and Dave Ramsey say it’s best to buy term insurance and invest the difference and deleting this commentary, please take a deep breath and hear me out. Remember, Suze and Dave are speaking to the mass market…everyday average Americans that don’t earn as much as you do. There is no one strategy that fits every person in every situation. Some people should absolutely buy term insurance to protect their families in the event of death of the breadwinner(s). Other people, typically higher income earners, can benefit greatly from a well-designed permanent policy.
Many upper income Americans have chosen to park some of their hard-earned wealth in permanent life insurance policies that provide them with tax-free growth on equity (cash value) and tax-free withdrawals as well. This type of policy, sometimes referred to as the Rich Person’s Roth, is sometimes even more beneficial for upper income women. Given women on average live longer than men, not only do they pay less for life insurance but the assets have more time to compound without tax.
While I’m confident you are familiar with the concept of investment diversification, you may not be as familiar with the concept of tax diversification. Put simply, tax diversification is the strategy smart people use to ensure they have options regarding how they will be taxed when they withdraw money from their investments. If the only place you ever saved money for retirement is your 401k, you may find yourself regretful when you start making withdrawals as every dollar is taxed as ordinary income.
This means if you need $100k for living expenses you’ll need to withdraw more than $100k to have the cash to pay the taxes due. Having money in a bucket from which you can withdraw and pay zero income tax can be very valuable, especially if income tax rates are high. The only way to ensure you, and not the IRS, get to decide how much income tax to pay is to have money in both types of instruments. If tax rates are reasonable then take more (or all) from your 401k or IRA. If tax rates are high, take a smaller amount from your 401k or IRA and the balance from your tax-free bucket.
Let’s now look at some of the characteristics of the Rich Person’s Roth that make it a compelling strategy:
Tax Benefits
Permanent life insurance policies provide significant tax advantages. The cash value within these policies grows tax-deferred, similar to retirement accounts like IRAs and 401(k)s. This means high-income earners can accumulate wealth while deferring taxes on the growth of equity (cash value) inside the policy for decades. Additionally, the death benefit is generally paid tax-free.
Insurance Protection for Life
Unlike term life insurance, permanent policies offer insurance protection that is designed to be in-force for the remainder of the insured’s lifetime. I’ve had many clients buy term insurance when they were relatively young, thinking they wouldn’t need life insurance after the term policy expired, only to find themselves pursuing another policy, at much higher premiums (if available at all), because they found the desire to protect their spouse and/or kids hadn’t gone away as expected. There are myriad reasons why having lifetime protection is valuable, the most obvious of which is to provide tax-free inheritance to kids and grandkids. There are many others, particularly when one’s estate is comprised of relatively illiquid assets. The death benefit can also provide liquidity to cover estate taxes, lessening or removing the need for heirs to fire sale illiquid assets to pay onerous estate taxes.
Equity (Cash Value) Accumulation and Access
To create tax-free income, you technically take a loan against the death benefit from the insurance company during your lifetime. The insurance company will likely charge you interest, so utilizing a company and policy with a zero net loan, or very low net interest, is of great value. In this situation, you pay interest on the loan and the insurance company credits you with interest on the equity (cash value) you have borrowed as if it is still in the policy.
To illustrate this, I’ll use a real estate analogy. Let’s say you purchase a home and secure a mortgage. Each time you make a payment you build more equity because part of that payment is repayment of principal. Additionally, over time, home prices tend to rise, adding to the equity in your new home. You do not pay any tax on the growth of equity in this home. Additionally, you can access this equity with a home equity loan. Because it is a loan and not income, there is no tax on the loan proceeds you receive. If you die with an outstanding loan balance, the balance will need to be repaid.
Permanent life insurance works in a similar fashion. Growth of equity (cash value) in the policy is not taxed, you can access the equity (cash value) without tax via policy loan, and any outstanding loan balance is subtracted from the policy death benefit before being paid out. This feature provides financial flexibility and can serve as an additional source of tax-advantaged retirement income.
Business Protection
For high-income business owners, permanent life insurance can be used to fund buy-sell agreements. In the event of a partner's death, the surviving partner can use the death benefit to buy out the deceased partner's share, ensuring business continuity.
Health Matters
Let’s be clear, the strategy being discussed uses life insurance as a tool to create financial flexibility. It is not a retirement plan though some companies market it that way. Health is an important aspect of this strategy. The better the insured’s health, the lower the cost of insurance inside the policy. Generally speaking, health tends to decline, not improve, over time. All of us may be one medical diagnosis away from becoming uninsurable, so securing a life insurance policy while health is good is something to be mindful of.
Summary of Characteristics
While permanent life insurance typically comes with higher premiums than term life insurance, its combination of lifelong coverage, tax benefits, equity (cash value) accumulation, and business and estate planning advantages make it an attractive option. By leveraging a well-designed policy, higher income earners can create financial flexibility and tax diversification they will likely find very valuable as they get older.
What would you say if I said you can put as much money into your Roth IRA as you wanted? How much would you contribute? While the Rich Person’s Roth is a specially designed form of a life insurance policy and not a retirement account, if used properly, it can create tax diversification and shelter some of your assets from tax for the remainder of your life.
Again, the Rich Person’s Roth works best for people who have already maxed out their retirement accounts and are looking for other tax-advantaged places to put money. The cash value of the life insurance policy can be an amazing tool to increase your income in retirement without associated tax. This tax-free income will not push your other income into higher tax brackets or increase your premiums on Medicare.
If this idea is of interest to you, please reach out to arrange some time for a conversation. If you think it may be of interest to someone you know, feel free to share this commentary and/or encourage them to contact Elevate.
Ken Armstrong, CFP®, RICP®, ChFC®, CLU®, CASL®, CLTC
CEO & Senior Wealth Management Advisor
Elevate Capital Advisors
Legal Information and Disclosures
This commentary expresses the views of the author as of the date indicated and such views are subject to change without notice. Elevate Capital Advisors, LLC (“Elevate”) has no duty or obligation to update the information contained herein. This information is being made available for educational purposes only. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Elevate believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based. This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Elevate. Further, wherever there exists the potential for profit there is also the risk of loss.