Most people have two investment accounts:  

(1)   a traditional retirement account that uses pre-tax contributions, accumulates tax-deferred, and distributes payments fully taxable as ordinary income.

(2)   a traditional investment account funded with after-tax contributions, accumulates with current taxation (1099s every January) and may be subject to capital gains when sold for retirement income.

The first works very well if every year of retirement one is in a lower income tax bracket than when the dollars were contributed. The second works very well if every year of retirement one takes distributions in an up market.

But, what happens if during some retirement years, an individual is in a higher income tax bracket and/or investment markets are down?

Using life insurance in retirement planning

Assume a hypothetical client is 35 years old with parents who are both age 60. How old will they be when the client retires?  If the client retires at 65, they will be 90 or already gone. 

What if the client were to purchase individual or survivorship life insurance on the parents using a portion of his or her retirement planning budget?  They may not be gone when the client retires. But if not, they certainly will die during the client’s retirement.

Just look at the internal rate of return on premium to death benefit.

If they die before actuarial life expectancy, then the client’s return is like winning the lottery (lousy lottery to win, as the parents died early). 

If they die during actuarial life expectancy, then the client’s return is like that of the stock market, usually between 5 and 9 percent. (Remember: the death benefit is tax-free, but funded with after-tax dollars.)

If they die after actuarial life expectancy, then the return is like that of a bond, usually between 2 and 5 percent (but again, tax-free).

But, who wants to talk to their parents about insuring their lives?  Sounds quite morbid, doesn’t it?  That’s what every child says, but every parent says, “Why not, if it doesn’t cost me anything.  And, while you’re at it, tell your brother and sister about the idea.”

Take that same 35 year old.  Will he or she likely be in a higher income tax bracket at retirement or a lower income tax bracket than he or she is in now?  If upwardly mobile, then why focus all of his or her retirement savings on pre-tax contributions?

Instead, consider setting aside at least a portion of the retirement savings budget with after-tax contributions that accumulate tax-deferred and are distributed tax-free in Roth IRAs, if within the income limits.  Phase-out in 2014 occurs between:

$0 and $10,000 for married filing separately

$114,000 and $129,000 for single or head of household

$181,000 and $191,000 for married filing jointly

Or fund a portion of the client’s 401(k) contribution in the Roth 401(k) option, if available in the retirement plan, with no income limits.  There are contribution limits for both the Roth IRA ($5,500 if under age 50; $6,500 if age 50 or over); and Roth 401(k) ($17,500 if under age 50; $23,000 if age 50 or over).

How much life insurance should he or she have on his or her own life?  Term insurance plus a Roth IRA or Roth 401(k) is very much like permanent life insurance with cash value, except that there are no contribution limits or income phase-out restrictions. 

  • The cash value operates like a Roth look-alike account; and
  • The death benefit can be used to reimburse heirs for a Roth conversion at death.

Using annuities and other risk-hedged alternatives in retirement planning

In today’s still low interest rate environment, this is a good time to lock in a mortgage, not to lock in fixed income.  Fixed income (from fixed annuities) results in lowering one’s standard of living (purchasing power, cost of living) throughout retirement, when there is inflation.  However, a fixed annuity does provide a guaranteed level of income for fixed expenses.  But what expenses really ever remain fixed?

Annuities that give the upside of the investment markets with downside protections are quite beneficial for the most risk-averse clients.  They allow the most risk averse to remain invested even in down markets, when most run for the hills.

One can buy covered calls, protective puts, stop-losses, etc. on individual securities and exchange traded funds (ETF) and notes (ETN), but not mutual funds.  Compare the fee for that to the fee for the lifetime benefits available in other than fixed annuities.  To fund the optimal retirement distribution plan, all you need are answers to several simple questions:

(1)           When will you die?  When will your parents die?

(2)           What will interest rates and investment returns be during all of those years?

(3)           What will inflation be for all of those years?

(4)           What will tax brackets be for all of those years?

I told you that the questions were easy.  I didn’t say that the answers were.  Since you cannot answer them with any degree of certainly, to have a retirement portfolio for all seasons, you need to have four portfolios in place.  Two of the four will be optimal in each year of retirement depending on whether tax rates are up or down and whether investment markets are up or down that year.