Recent world events have made it clearer than ever that it’s imperative to have a long-term financial strategy that allows you to weather volatile economic times. The Roth IRA is a popular tax-minimizing strategy, as it allows for tax-free growth and withdrawals in retirement, and many people make it part of their long-term financial plan. Unfortunately, high-income earners are either limited or ineligible when it comes to Roth contributions. At the moment, that means single individuals with incomes greater than $139,000 and couples with incomes greater than $206,000 in the year 2020 can’t take advantage of Roth IRAs the way those under these thresholds can.
Fortunately, there are a few ways around this. A Backdoor Roth lets you convert a traditional IRA to a Roth – even if your income precludes you from contributing directly to a Roth – through what amounts to some intricate paperwork. We help clients do this carefully and make sure that they report them properly on the tax returns. The option I’ll discuss below, however, is a different type of tax-advantaged investment altogether. It’s called the Rich Person Roth and, though it’s not for everyone, it can be incredibly valuable for some high earners.
Rich Person Roth: The Basics
An ongoing concern for those with high incomes is the amount they’ll lose to federal, state, and local taxes. Naturally, it’s ideal for high-income earners in this scenario to find ways to pay less in taxes and, therefore, have more money available now and in retirement. The Rich Person Roth does this through a vehicle that is quite dissimilar to a Roth IRA, but that offers comparable tax benefits without waiting until age 59.5..
What we’re talking about here is actually a type of cash value life insurance, and it’s a strategy that could help you unlock financial independence. It doesn’t apply to just the super-rich either. If you’re ineligible for a Roth IRA and you’re contributing the maximum to your 401(k) or IRA ($19,500 annually or $25,500 if you’re 50 or older and making catch-up contributions), you may be a great candidate for the Rich Person Roth.
Understanding the Details
To be clear, this strategy isn’t about whether or not you need life insurance. Rather, it’s a way to park some of your hard-earned money in an IRS-approved cash value life insurance policy. This allows for tax-free growth and tax-free withdrawal. You can overfund this whole life policy by creating a large balance of cash value that can grow. The insurance costs are small compared to the cash value. The younger you are when you start the policy, the longer your assets have to compound tax-free, and there are no contribution limits if you set the policy up properly. IRS has the limit on how much you can put in each calendar year based on your age and death benefit amount to make sure this policy doesn’t violate the rules in order to offer the tax-free benefits. (Your options will vary by the insurance company, so do your research before signing on the dotted line.)
Since this type of life insurance is permanent, premiums will be higher than term-life policies. However, the benefits are much greater if you’re looking to minimize your taxes as the growth of cash value is not reported to IRS and you do not pay income taxes each year. As the policyholder, you can use the cash value of your life insurance by taking out a loan and choose to pay back base on your own schedule. Because you use the cash value as a loan, you don’t need to report the cash you take out as an income on your tax return. The interest rate charged by the insurance company is generally not a high-interest rate. Since you pay low-interest rates on the loan and you can earn return from the cash value without paying taxes, the compound impact on the difference between these two rates over time is powerful. The only time the loan balance must be paid back is the time when you die and the insurance company will pay your beneficiary the difference between the death benefit and the loan balance. The death benefit is income tax-free to your beneficiary.
You generally can use about 95% of the cash value as the loan, unlike when you borrow from your 401(k) plan that is limited to a $50,000 loan amount.
The first year is going to be the most expensive, but after two years, you’ll see the benefits of liquidity and lower costs. If you can generate 4% tax-free benefits without taking the same market risks as your other investments in your IRA or 401(k), you can build wealth much faster. It’s also a great way for those playing a serious game of catch-up to hit their retirement savings goals faster if they’re already maxing out catch-up contributions elsewhere.
When you think about some of the main sources of risk to your financial security in retirement, taxation, stock market volatility, and longevity likely come to mind. The Rich Person Roth allows you to mitigate against all three of these by creating an income stream for life that lessens your overall financial risk. This tax-free income will not push you into a higher tax bracket or increase your Medicare premiums in retirement.
The Rich Person Roth sounds like a pretty smart strategy, right? Well, while it’s perfect for some, there are drawbacks to consider that may make it a poor strategy for others. For instance, one of the perks of contributing to other types of retirement accounts is that contributions are tax-deductible. There is no tax deduction available on Roth IRA contributions, nor is this an option with the Rich Person Roth. You will pay taxes on any income you contribute to your cash value life insurance policy, so if tax deductions are your main motivator for socking away more money, this tool won’t help you in the short-term.
Since we’re talking about a life insurance policy here, it’s also necessary to point out that those in poor health may find this a troublesome strategy. Even if you never intend to use your Rich Person Roth as life insurance, you’ll still be required to undergo a medical evaluation that could disqualify you from the underlying coverage or saddle you with steep premiums. So, if you’re in poor health, a Rich Person Roth will be less advantageous for you.
Keep in mind that the longer you expect to live, the more time your money can benefit from the magic of compounding. However, because the cost of life insurance is so steep with these types of policies, it could lower your net returns.
It’s also important to carefully consider what percentage of your assets you want to place into this type of retirement planning tool. The optimal balance between your Rich Person Roth and your other tax-advantaged accounts will be a bit different for everyone, so you may want to enlist a trusted financial advisor for guidance in using this strategy to maximum benefit. This financial advisor must understand your entire financial picture and goals and has access to a board selection of insurance companies to design the right strategies for you.