A high income brings many benefits. Unfortunately, easy access to tax-free growth is not one of them. With the IRS barring higher earners from Roth IRAs, investors must find other sources of tax diversity in retirement. This article will discuss one such strategy: the Roth Alternative indexed Universal Life (iUL).
Let’s start from the top. What is tax diversity, and why is it important?
Tax diversity is key to keeping you and your portfolio flexible in retirement. With the still new Trump presidency, no one knows where taxes are heading in the next few years, not to mention over the decades after you finish working. This can be risky for retirees, who often live off a fixed investment portfolio. An unexpected tax hike can erode away the value of savings, making retirement more expensive than anticipated. Retirees can protect themselves with tax diversity, or investing in strategies with different tax treatments.
How can high income individuals achieve tax diversification?
Most individuals hold both tax-deferred (401(k) and IRA) and taxable (individual brokerage account or checking/saving accounts) assets. However, less hold assets completely free of tax. One option is the Roth IRA. Unfortunately, the government strictly limits Roth IRA contributions. For 2017, married taxpayers with incomes over $196,000, or single taxpayers with incomes over $133,000, are barred from directly saving in a Roth. Even when eligible, the yearly contribution is limited to $5,500, plus an extra $1,000 for earners age 50 and up.
Some investors bypass the income limit with a backdoor Roth IRA, where they convert Traditional IRA assets into a Roth IRA. For those with a large amount of non-taxed IRA contributions, however, this strategy can be quite pricey, as up to the entire IRA may be hit with ordinary income taxes.
Those lucky enough to have a Roth 401(k) through work have a great advantage. The income limit doesn’t apply, and they can save much more: $18,000 per year, plus an extra $6,000 once you’ve reached your 50th birthday. However, higher earners may wish for more tax-free savings even after maxing out their company’s Roth 401(k) plan.
The Roth Alternative iUL policy
This is where the Roth Alternative iUL comes into play. An individual will take out a life insurance policy and pay premiums over time, usually 10 years, and then drop the death benefit to the lowest amount possible. During retirement, the policy owner can borrow tax free against the policy. As long as the policy doesn’t lapse, the loan will be paid off by the death benefit. In this way, the Roth Alternative iUL acts like a hyper-charged Roth IRA.
How does the Roth Alternative strategy work?
Insurance policies offer unique tax advantages. All investment growth and income is free of income and capital gains taxes. The death benefit is also often entirely tax-free.
Also, withdrawals are free of tax as well. While withdrawals of policy value may incur taxes, the owner can borrow entirely tax-free. And, as long as the policy is kept in force, the tax-free death benefit pays off the loan, meaning that the withdrawals escape all taxation.
Also, unlike a Roth IRA or 401(k), an iUL policy has no contribution or income limits. This makes a high-earning policy owner free to save much more for retirement.
What are the benefits of the Roth Alternative strategy?
First, it gives higher earners access to Roth-IRA-like, tax-free growth. Another bonus for risk-adverse investors: this growth is usually guaranteed against market losses. Most iULs offer a minimum “floor”, where your investment returns can’t fall below a certain level. Even if the market dips 50% or more, this guarantee keeps your policy value safe.
This strategy also allows for more tax-sheltered savings. All “official” qualified retirement plans, such as a 401(k) or a defined benefit pension plan, limit your yearly savings. Because the Roth Alternative strategy isn’t a true retirement plan, it bypasses these limits.
Finally, this strategy comes with a built-in safety hatch. As a life insurance policy, it comes with a death benefit. Should the earner pass away a few years into the contract, this benefit acts like an instant return on the cash value and can help compensate the family for the lost income. Some policies also give a chronically ill policy owner early access to this benefit to pay for medical or long-term care costs.
This sounds too good to be true. What’s the catch?
Just like anything else in financial world, the Roth Alternative iUL strategy has its own list of “cons”.
The major drawback is the time frame. This is no “get-rich-quick” strategy; it’s designed for the long-run. This is because of the upfront price tag. Life insurance guarantees that the company will pay a set amount once the insured pass away, even before receiving all of the premium payments. The difference between the policy value and this guarantee, the “net amount at risk”, is especially high in the beginning. To protect themselves, insurance companies charge high initial fees, which lowers the policy value. If you need to access the funds right away, you may not be able to recover your premiums.
It is important to note that these fees go down over time. The Roth Alternative strategy in particular has low total fees because it aims for a high cash value and low death benefit (read: a small amount “at risk” to the insurance company). Since the insurance company has less at risk, it lowers your fees. In most cases, a well-designed Roth Alternative iUL over time may cost just the same as a Roth 401(k).*
The other major drawback is the insurance company risk. Your “guaranteed” returns are only as good as the company making the guarantee. If the insurance company runs into financial trouble, the investor may not receive their full benefit. While investors face this risk for any life insurance product, it is even more important for the Roth Alternative iUL. Since the strategy is for the long haul, you must trust the insurance company to last throughout your retirement. Don’t fall for a cheap quote; invest in yourself by selecting a quality carrier from the start.
Is the Roth Alternative strategy a good fit for me?
There are a few more things to consider before taking out a Roth Alternative iUL policy. First, because the strategy often takes a decade to “mature”, it works best for earners still far from retirement, usually between 45-53 years of age.
Second, you must carefully maintain the strategy. This is no “set-it-and-forget-it” plan. Policy owners must lower the death benefit after paying all premiums to get the most for their money. Also, the policy cannot lapse. If so, the policy owner will face a tax nightmare.
Finally, remember that this strategy requires a diligent investor dedicated to long-term savings. It takes years of disciplined premium payments, and then more waiting before finally taking out income.
Still have questions?
This article is meant as an introduction to the Roth Alternative iUL strategy. Every individual’s financial situation is unique and must be treated that way. Contact our office today to discover whether a Roth Alternative strategy is a good fit for your situation.
The information provided here is general in nature. It is not intended to be, and should not be construed as, legal or tax advice.
Investment advice is offered through Stratos Wealth Partners, Ltd., a registered investment advisor.