Insurance as an investment???

I get so angry when I get a call from a person telling me that so and so with XYZ insurance has told him it is better to invest his money in a life insurance policy and take it out tax free for retirement than to invest it into an IRA or some other kind of investment that could grow tax deferred and be potentially taxable later at a higher rate than they are in now.  Their rationale:  “Taxes are so low now that they can only go up by the time you retire.”

While it is true that life insurance does provide the owner of the policy the chance to Borrow Money on a tax free basis … it is not a miracle.  All loans are tax free whether they come from an insurance company, an investment company, a bank or your Uncle Jethro.  Here is what they are not telling the owners of the policy (and by the way it is the owner that has this option … not necessarily the insured unless the insured is the owner also); if the policy should lapse before the insured person dies, and the loan has not been repaid, it becomes a distribution that could be subject to taxation.  However, the only thing that would be subject to taxes (and this is usually minimal) is the gain in value.  Naturally, any principal investment that was taxed before paid into the policy would simply be treated as a return of principal which is tax free.

They also promise returns of 5% now … which is not necessarily true either.  In one case a person was required to invest $20,000 per year for 10 years (a total of $200,000) on a $306,665 policy death benefit.  If the policy only returned guaranteed values, after ten years the owner would have accumulated $177,439 in value.  Under current cost and values (which includes dividends being used to purchase paid up additions and continue to provide commissions to the selling agent) the policy cash value would grow to just $212,574 while the death benefit would have also grown to $367,387.

Now if a person simply invested $20,000 per year for ten years at 5% per year they should be able to accumulate $251,557.85.  So looking at the guaranteed side of the policy the real cost of doing business with the insurance company was $74,118.85 over a period of 10 years … and on the non-guaranteed side the cost of doing business was $38,983.85.

Just about the time most people realize this … they are in their 10th year and it is generally too late to do anything about it.  For those who cancel the policy and take their cash value … they are not hurting the insurance company that much — after all, they had the persons money for 10 years and now with the policy cancelled will never have to pay a death benefit.  Let’s face facts … most insurance companies own the tallest buildings in the world not to mention literally thousands of land acreage.  They do not acquire this wealth by being broke or making bad bets.

Another thing that struck me the wrong way on this deal is that the person who purchased the policy … in this case … had told the insurance agent that his primary objective was to leave his wife in good financial condition should he die early.  Unfortunately, since the husband in this case was uninsurable, the agent chose to write the policy covering the wife’s life … which means at the husband’s death … there is no benefit to her at all – but at her death there would be a tremendous benefit to the husband who is capable of providing for himself.

Finally, the rate provided in the illustration was Super Preferred … which means this female of a senior age would have had to been in the shape almost as good as an American Astronaut in order to qualify for this superior rating.  Why is it that insurance agents don’t show illustrations at the standard rate – and if the person qualifies at the better superior rates – good – but if they don’t they won’t be disappointed.

I’ve literally seen this face too many times when, as a young person working in the Financial Services Industry I would Overpromise and Underdeliver just to try to make the sale and put food on my table for my family.

 

 

 

This is how the insurance company protects themselves with this:

Now I am not really knocking these life insurance policies … I am upset with the way they are being sold, however.  Life Insurance has a primary objective of providing cash at the death of a person so that the people that person leaves behind can continue to live in some form of decent lifestyle.  There are some secondary advantages, like the accumulation of cash value … but these should only be considered when all other forms of accumulation have been exhausted and taken advantage of.

The fact is … if you are only looking to protect yourself against death for 10-20 years into the future … you do not need a permanent whole life policy.  A term policy, which cost much less per 1,000 of death benefit because there is not cash value accumulation may be a better buy.  In this person’s case they could have probably purchased a 10 year term policy for about $1,200 per year or a 20 year term policy for about $2,000 per year and still would have had between $18,000 and $18,800 to invest where they could really do well for themselves and not the insurance company so much.

Tax Rates are going to be higher when you retire!!!

Well this may or may not be true … but even if it is … I hope to prove here that it really is not a reason to forego a traditional IRA or other retirement plan that is tax deductible now and tax deferred until used, as compared to investing in after tax vehicles.

First let’s take a look at Historical Top Tax Rates on Individuals.  I pulled this chart off the internet and I think it has been used by many writers.  I remember seeing it first back in 1992 when I was studying the taxation portion of the Certified Financial Planners Designation test (I did give up my CFP Designation when I retired last year).

Now this chart skips some years … for those of you who are a little more analytical that want to see a year by year table … I have included that for you as well from the www.taxpolicycenter.org.

As you can see … top tax rates went much higher in the 1930’s, 40’s, 50’s and 60’s.  We had a depression to finance as well as a World War and a Korean War during those years.  Even though we had the Vietnam War in the 60’s and 70’s tax rates started to drop.  Then with supply side economics of the President Reagan years (Mid to Late 80’s) tax rates went as low as 28% before they started to once again increase under the George Bush (the Dad), Bill Clinton, George Bush (the Son), and Barack Obama Presidential Periods.

Next — before getting into my analysis — you need to understand what a top Marginal Tax Rate is.  Here it is as defined by Wikepedia.com

A marginal tax rate is the tax rate incurred on each additional dollar of income. The marginal tax rate for an individual will increase as income rises. This method of taxation aims to fairly tax individuals based upon their earnings, with low-income earners being taxed at a lower rate than higher income earners.  Of course to hear some of today’s politicians, this is still not a fair way to tax people.  They think top income earners should be paying 100% of the tax bill.  It does not matter that based on the Pareto Principle 20% of American Taxpayers are probably already paying 80% of the tax bills in the country.

In 1906, Italian economist Vilfredo Pareto noted that 80% of Italy’s land was owned by 20% of the people. He became somewhat obsessed with this ratio, seeing it in everything. For example, he observed that 80% of the peas in his garden came from 20% of his pea plants.  The 80:20 ratio of cause-to-effect became known as the Pareto Principle.

 

 

When it comes to who pays the most … will the Pareto Principle hold true?  Pretty darn close:

Approximately 76.4 million or 44.4% of Americans won’t pay any federal income tax in 2018, up from 72.6 million people or 43.2% in 2016 before President Trump’s Tax Cuts and Jobs Act, according to estimates from the Tax Policy Center, a nonprofit joint venture by the Urban Institute and Brookings Institution, which are both Washington, D.C.-based think tanks. That’s below the 50% peak during the Great Recession. They still obviously pay sales tax, property taxes and other taxes.

Considering individual and payroll taxes, and other sources of federal tax income like excise taxes (on specific products like fuel, alcohol, and so on), the top 20 percent of American households pay nearly 70 percent of taxes in the United States, according to an analysis by the Tax Policy Center.

The top One Percent in America earns at least $480,930 per year, according to recently released IRS data that compiled earnings/taxes paid from 2015. While that One Percent of Americans makes about 20% of all dollars earned in America, they pay 39% of all taxes paid to the American government.

If you think the tax system in American is not fair and slanted against you … you may be right … but let this chart sink in and be careful what you ask for.

BREAKING DOWN Marginal Tax Rate

Under a marginal tax rate, tax payers are most often divided into tax brackets or ranges, which determine the rate applied to the taxable income of the tax filer. As income increases, what is earned will be taxed at a higher rate than the first dollar earned. While many believe this is the most equitable method of taxation, many others believe this discourages business investment by removing the incentive to work harder.

So when you see 91% tax rates in Figure 4 above, this does not mean that a person who may have earned $100,000 in 1960 would have paid $91,000 in taxes. On the contrary, here is the tax rates for that year for a married person filing a joint return (source: Web Stanford/edu):

 

Working through the numbers, a person who was married filing a joint return in 1960 and earning a total of $100,000 of taxable income would have paid 20% of the first $4,000; 22% of the next $4,000; 26% of the next $4,000 – etc.  I have worked the numbers out and here is the amount that would have “taken that one-way trip east.”

 

As you can see here, a person earning $100,000 in 1960 would have paid $53,640 in taxes assuming all income was taxable.  This is an average tax rate of 53.64% even though his marginal top tax rate was 72%.  That rate was only taxed on the last $12,000 of income.

 

As a matter of fact, to even get to a 91% tax rate this person would have had to earn $401,000 in 1960 then that last one dollar would cost $0.92 (92 cents) in taxes.

Yes, I call it a One-way Trip East because, believe me, the people paying it will not see much in return since our government is just too busy handing out money to those that don’t pay any in.  Now on with the rest of this before I get onto another soap box that could go on forever.

Now let me show you the tax rates of 2019 before moving on…

As you can see, these are the tax rates for Married Filing Jointly.

Investing With Taxable-Taxable Investments Rather Than Tax Deferred – Taxable Investments …

So, if a person’s tax rate is “bound to go up” as some insurance professionals profess wouldn’t it be better to pay the tax now at lower rates and save taxes later?

Well that depends on if you simply want to save taxes … or if you really want more for the older person you hope to live to be someday.  Let me show you what I mean.

Here’s some assumptions I will make for the accumulation phase of the investment period.  I will show the distribution phase assumptions later.

As you can see I have kept the tax rate at 24% so for in a 2019 situation the family would have to be earning in excess of $168,400 to hit this tax rate.  I wanted to start high so I could ultimately finish a lot higher.  You will also see in this first scenario I will be keeping tax rates the same for pre and post retirement.  I will change the post retirement tax rate in future scenarios.  Keep in mind also, that by their very nature of being interest earnings, they are last dollars earned so will be taxed at the taxpayers highest marginal rate.  It is also important to remember that “Capital Gains” bear a maximum tax rate for all taxpayers, regardless of income, a flat rate of 20%.  The word on the street is that some of the more liberal politicians are going to attempt to change this and have Capital Gains taxed as Ordinary Income.  And, I heard just today that there is a bill coming before congress to charge a “stock transaction tax” everytime a stock is bought and sold … in addition to income tax.  This is another soap box that I will not get on at this time.  For now … let’s look at the numbers.

Scenario 1:  Investor earns $5,000 and wants to put the after-tax amount to work at 10% interest before taxes.  He happens to be in a 24% top tax rate and the $5,000 (as well as the interest thereon) is last dollars earned in that rate.  Here’s the accumulation table:

As you can see in this table in year one … only $3,800 got invested because this would have been what was left after tax was paid on the $5,000.  I could have done this another way and said to earn $5,000 after a 24% tax rate the person would have to earn $6,578.95 and then deduct 24% in taxes ($1,578.95) to show a net amount of $5,000 being invested — but that would require more columns and could have been more confusing.

In this scenario the investment is $3,800 per year earning 7.60% after tax for a net value of $644,722.96 after tax at the end of year 35 when this 32 year old person today should be getting ready for a nice comfortable retirement.

Now what could happen after retirement?  This person could use a capital retention method of distribution where he takes only interest income from his accumulated wealth and leave the principal balance to be paid at his death to his loved ones – in this case $644,772.96.

If he were able to continue to earn 10% before tax or 7.60% after tax … he would have a total income of $49,002.75 each year after taxes were paid on his interest income of $64,477.30.  Of course if some of this were considered “Capital Gains Income” he could pay less in taxes since the maximum rate there is 20% currently (and assuming it does not change in the next 35 years).

Now let’s take a look at the next scenario.

Scenario 2:  Investor earns $5,000 and wants to put the before-tax amount to work at 10% interest tax deferred.  He happens to be in a 24% top tax rate and the $5,000 (as well as the interest thereon) is last dollars earned in that rate … however the $5,000 is put into an IRA (or 401(k) plan and is not taxed currently while the interest earned is tax-deferred.  Here’s the accumulation table:

As you can see in this table.  This investor has the full benefit of the $5,000 annual contributions and earnings on those contributions working for him.

Here he is able to accumulate a total of $1,490,634.03 before retirement.  However, none of this has been taxed.

If this person decided to take interest only payments (which he may be able to do regardless of laws requiring minimum distributions to begin at age 70-1/2) he could take out $149,063.40 each year and after tax still end up with $113,288.19 – which is still more than the $49,002.75 shown in Scenario 1 above.

However, we must keep in mind that this is still assuming a tax rate of 24% after retirement.  I will show what happens if taxes increase after retirement before I finish this article.

 

So where we stand right now … it looks like Tax Deferral is far better IF tax costs/rates remain the same for the investor post retirement as they were pre retirement.

Now let’s talk briefly about …

Capital Distribution vs. Capital Retention

Capital Retention simply means … living off the earnings of a capital amount and leaving the capital amount in tact for someone else or yourself someday.

Capital Distribution means taking distributions systematically of both Principal and Earnings on remaining principal until all capital is used up.

• For example:  Assume that the investment in Scenario grew to $644,792.96.  Now we know that all of this capital has already been taxed.  So if a person wanted to take money out of this account over a period of say 30 years … from age 68 to 98 in this case … they could pull out enough principal plus interest to deplete the account over a period of 30 years.  Beginning the 31st year there would be nothing left.
• Now of the $644,792.96 of value available the day of retirement … all of this would  have been taxed and not subject to taxes again.  Therefore if the person took this amount over 30 years, the only thing they would have to pay tax on would be any gain from year to year.  On average $21,492.43 could be considered a return of principal if one was averaging this over a period of 30 years.  In annuity language this is referred to as at tax exemption amount.  Why because it is principal that has already been taxed.
• With a tax deferred investment, all income would be taxed as “Ordinary Income.”  So the income off of $1,490,634.03 in this example would be taxed to the investor.

Summary of Net Tax Effects

The best way to summarize is to show the calculations and hope that you can hang in there with me.  Believe it or not … I am not a numbers person … I hate them as much as 50% to 75% of all the other people out there … but in this article I think they are necessary.

Example 1:  Tax Rates remain the same in Pre and Post Retirement Years —

Capital Retention:  Here we see that with tax rates remaining the same … considering Capital Retention you would have income in the tax deferred investment of $113,288.19 after tax as compared to the non tax deferred investment which would provide $49,002.79 after tax.  Looks to me that the tax deferred investment provides the biggest bang for the buck at 2.31:1 times more money.

Capital Distribution:  Here we see that with tax rates remaining the same … considering Capital Retention you would have income in the tax deferred investment of $90,016.63 after tax as compared to the non tax deferred investment which would provide $44,094.43 after tax.  Looks to me that the tax deferred investment provides the biggest bang for the buck at 2.04:1 times more money.

What happens if tax rates shoot to 50% the year you retire?

Example 2:  Tax Rates Sky Rocket to 50% Post Retirement —

Here we see that even at 50% after retirement tax rates you still end up with greater income on the Tax Deferred Investment as compared to the taxable investment.

• Capital Retention:  IRA or similar plan would provide $74,531.70 after tax compared to $32,238.65 (a ratio of 2.31:1)
• Capital Distribution:  IRA or similar plan would provide $46,175.18 as compared to $30,718.44 (a ratio of 1.50:1).

 

 

 

 

 

 

 

Well what about a 90% tax rate ???

Example 3:  Tax Rates go out of the atmosphere to 90% Post Retirement —

Here we can see that even at this ridiculous rate when it comes to taking interest only on your investment you still end up with a greater amount of income after paying 90% on the tax deferred investment as compared to the investment you paid tax on all along.

• Capital Retention: $14,906.34 after tax income as compared to $6,447.73 (a ratio advantage of 2.31:1)
• Capital Distribution:  Now in this 90% unlikely scenario you would be better off with the taxable investment as compared to the tax deferred investment.  Here the tax deferred investment after tax would provide an income of just $5,718.74 per year as compared to the $21,815.33 that you could get on the Taxable Investment.  This happens to be a ratio of (0.26:1).

 

The big question remains … though … just how much income would a person need to have to end up in the 90% tax rate 35 years from now?  Probably several million per year if income and taxes keep pace with inflationary pressures.

The Bottom Line …

If you really think taxes are going to be 3 to 4 times higher when you retire than they are today … then you should probably consider investments that are made after tax has been paid on earnings and that will be taxed on earnings each and every year between now and when you retire.

If you think taxes will actually be the same or lower when you retire … then you certainly should look to investing with before tax dollars and defer taxes on earnings of those before tax dollars.  In addition put as much as you possibly can here.

If you are simply not sure … and have a long time before needing the money … consider something like a Roth IRA or Roth 401(k).  Here you would invest after-tax capital to the plan … but all earnings in the plan would grow tax-EXEMPT and remain tax-EXEMPT when you start taking a payout.

Caution You must be in the plan (Roth IRA) for at least five years to get a tax free payout and if you take out money before age 59-1/2 you could be subject to an additional 10% tax penalty and lose the tax-exempt status of the IRA.   Also, if you make too much money you are not allowed to contribute to a Roth IRA.  It is recommended that you consider the services of a qualified Financial Advisor before considering a Roth IRA or an IRA and any investments to fund them if your knowledge is minimal and you prefer not to do your own research.

Finally, don’t let taxes scare you away from making good solid investments.  There is one thing for sure … if you have to pay taxes that means you made some money.  Here’s a question I used to ask my clients … regardless of tax bracket … but I will use the 24% bracket assumed in this article as an example.

Question:  “Mr. Client, would you rather me help you make a dollar so that after you send Uncle Sam his 24 cents you still have 76 cents left, or would you prefer that I help you lose a dollar so that after Uncle Sam reimburses you 24 cents for the dollar you lost … you will only have lost 76 cents?  In other words Mr. Client, does it make more sense to make 76 cents for each 100 cents you earn or lose 76 cents on each 100 cents lose?

I know that if you are a CPA or Tax Accountant … you love those tax losses to get some coming back from the east … but as an investor … as much as I hate taxes … I do love gains and investment earnings.  I wish it were possible to earn 25% per year with no risk and no taxes … but it is not and until it is we have to make do with what we have.

Good luck, now go make some waves,

Jerry Nix, FreeWaveMaker, LLC

Disclaimer:

This information is not recommendations for you to purchase or sell any investments outlined in this article.  The information is being shared for educational purposes only.  I recommend that you seek the advice of a licensed and competent financial advisor before taking actions on your portfolio if you see a need to after reading this article.

The author of this article is long on the following investments outlined herein: No Investments were Discussed.