Retirement can be a time of renewal. Time to stop and smell the roses, connect with old friends, travel to exotic lands. However, retirement is also a time of anxiety, especially if you haven’t prepared for it. Managing your taxes in retirement is one of the most important financial decisions you can make. The difference is how your money is taxed could mean the difference between going on trips to far-flung locales and struggling to pay the bills.
Hopefully, when you retire, you’ll have several different sources of income, from Social Security to the cash value of your life insurance plan. How these different sources of income are taxed can be confusing. In order to illustrate the differences taxes will have on your bottom line, we present a case study. We feel this is the best way to illustrate the impact of taxes on your retirement income.
How Much Income Tax Will You Have to Pay When You Retire with $140,000 Annual Income?
The short answer is “depend”. Depending on the sources of your income during retirement years, your income tax will be very different. We illustrate the differences in two scenarios below:
Mike lives in Los Angeles, CA. He is 66 years old and has lived in California all of his life. Lucky for Mike, since he was born in 1954 his full retirement age is 66. If he were born later than 1954, his full retirement age could be as old as 67. But Mike has reached full retirement age according to the Social Security Administration (SSA). Obviously, Mike would like to maximize the amount of money available to him while reducing the amount he owes to Uncle Sam. How much he owes to Uncle Sam depends on several factors, one of which is the sources of his income. Below are the two hypothetical scenarios of his incomes from different sources to illustrate the tax-free benefits of Indexed Universal Life Insurance (IUL).
Scenario 1
| Source | Account balance | Amount | TaxableAmount | Federal Tax Rate | State Tax Rate | After Tax Amount |
| 401(K) and IRA | $50,000 | $50,000 | 24% | 9.3% | $33,350 | |
| Other income | $10,000 | $10,000 | 24% | 9.3% | $6,670 | |
| Social Security | $30,000 | $25,500 | 24% | 9.3% | $21,509 | |
| Vanguard | $20,000 | $12,000 | 15% | 13.3% | $16,604 | |
| Vanguard | $333,333 | $6,667 | 24% | 9.3% | ($2,220) | |
| Roth IRA | $10,000 | $0 | $0 | $0 | $10,000 | |
| IUL | $20,000 | $0 | $0 | $0 | $20,000 | |
| Total | $140,000 | $104,167 | $105,913 | |||
| 76% |
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As we can see, Mike has prepared for retirement and will enjoy a fairly substantial after-tax income. He has diversified his portfolio and has taken advantage of a Roth IRA, which is taxed before you deposit the money, so when you withdraw it the money is tax-free. He has also invested in an Indexed Universal Life Insurance (IUL) policy, which will also afford him some tax-free income. In this scenario, although his total annual income is $140,000, after paying income tax, he has only $105,913, which is 76% of his total income. He has to pay income tax equivalent to 24% of his total income.
Also, keep in mind that Social Security Income is taxed at different rates, depending on your Adjusted Gross Income (AGI):
- 50% of Social Security is taxable income if adjusted gross income is greater than $25,000;
- 85% of Social Security is taxable income if AGI is greater than $34,000
The basis in Vanguard account is 40%, which means $12,000 of the $20,000 distribution is subject to Long Term Capital Gains tax rates. In addition, the Vanguard S&P 500 fund generates on average a 2% taxable distribution per year based upon the internal functioning of the fund. This taxable distribution is taxed at ordinary income tax rates. Most investors purchases additional shares of the fund with their annual taxable distribution amount which increases their basis but requires them to use other personal funds to pay the tax bill (hence the negative number in the after tax column).
But let’s say that Mike is a savvy investor and has put more money away in his IUL years before he was set to retire. What will that do to his bottom line?
Scenario 2
| Source | Account Balance | Amount | TaxableAmount | Federal Tax Rate | State Tax Rate | After Tax |
| 401(K)IRA | $30,000 | $30,000 | 24% | 9.3% | $20,010 | |
| Other | $10,000 | $10,000 | 24% | 9.3% | $6,670 | |
| Social Security | $30,000 | $25,550 | 24% | 9.3% | $21,509 | |
| Vanguard | $0 | $0 | 15% | 13.30% | $0 | |
| Vanguard | $0 | $0 | 24% | 9.30% | $0 | |
| Roth IRA | $10,000 | $0 | $0 | 0% | $10,000 | |
| IUL | $60,000 | $0 | $0 | 0% | $60,000 | |
| Total | $140,000 | $65,500 | $118,189 | |||
| 84% |
As we can see, if Mike had put more money into his IUL account earlier, his after-tax income would rise to $118,190, or $12,276 more than he had in the first scenario when he only put $20,000 into his IUL account. This helps increase his after-tax income by 12%. And he only pays 16% of his total income in tax, compared to 24% in the scenario above.
That $12,276 is nothing to sneeze at. Mike could use the extra money to take a nice vacation, remodel part of his home, or provide some college tuition money for any grandchildren he might have. It’s basically free money for Mike, since it would be going for taxes if he had not put the money in a IUL account. This is the biggest benefit of having an IUL policy for retirement savings purposes.
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>>MORE: Understanding Indexed Universal Life Insurance – Is It Good for Retirement Savings?
What is Indexed Universal Life Insurance?
Indexed Universal Life insurance is a permanent life insurance policy with a cash value account attached. Unlike whole life insurance, the cash value account in an IUL policy grows according to an indexed account.
>>MORE: Compare Whole Life Insurance with Indexed Universal Life Insurance
The indexed account earns interest based on market performance. This is a lower-risk and lower cost type of investment because it reflects the entire market. The entire market is not going to go bankrupt, like individual stocks can. It’s considered low-cost because it’s a passive investment. An index account just follows the market; there’s no need for someone to keep an eye on the stock market and estimate which stocks are selling at a profit.
There are usually caps and floors associated with an index universal life policy. A floor is the least amount of interest you can earn, even if the market actually loses money. Investors will recall the stock market crash of 2008, where the market suffered a 50% loss. However, if you had an IUL policy with a floor set at 2%, 1%, or 0%, you would not have lost money.
On the other hand, these accounts also come with a cap, which is the most interest you can earn. If the market surges and returns a 30% gain and your cap is set at 12%, you will earn 12%.
>>MORE: Should I Invest in S&P 500 Index Through a Indexed Universal Life Insurance Policy?
Since IUL is a permanent life insurance policy, it lasts for your entire life. There is a tax-free death benefit available for heirs when the policy holder dies. The main benefit as far as retirement goes is that it makes more of your own money available to you by offering a tax-free disbursement.
>>MORE: Why is Indexed Universal Life Insurance a Good Option for Retirement Savings?
Last Thoughts
Preparing for retirement can be tricky. You want to maximize the money left in your pocket while minimizing the money you must pay in taxes. There are many solid retirement strategies, but savvy investors should add to their portfolios by investing in a IUL policy. This will offer both a tax-free death benefit and a tax-free cash value account you can enjoy during your golden years.
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