Tax Shields

Posted January 2009; Revised January 2015 – John Spitzer & Todd Houge

One of the major principles of wealth management is to use tax shields in order to defer taxes on the earnings of your portfolio. Because of the generally long time horizon in wealth management, the impact can be quite large. Because there are several major tax shields, this section of Basic Principles is more extensive than some of the others. The contents of this section are:

Impact of Tax Deferment

Suppose you and I each invest $10,000 for 30 years at a compound 10% average return per year. We both have the same tax rate – a combined Federal and state tax rate of 32% per year. I pay taxes on my earnings every year but you are able to wait until the end of the 30-year period and then pay tax on your total earnings. Who will have more money, and how much more? For my part, my portfolio earns 10% each year but I pay 32% of those earnings in taxes. Put differently, I keep 68% of my 10% return – my after-tax return is 6.8%. (Putting in some numbers, my pre-tax earnings on $10,000 are $1,000. But I pay $320 in taxes so my after-tax earnings are $680, which is 6.8% of the $10,000.) So, after 30 years, I have: $10,000 x (1 + 0.068)30 = $71,968 For your part, you don’t pay any taxes until year 30. Your pretax balance at the end of 30 years is: $10,000 x (1 + 0.10)30 = $174,494 All but $10,000 is taxable, so you will pay taxes = 0.32 x $164,494 = $52,638 Which leaves you with an after-tax balance = $174,494 – $52,638 = $121,856 Let’s see … I have $71,968 and you have $121,856 – you have about 70% more money than I have! Can I trade?

Traditional 401k (and 403b) Plans

The Traditional 401k and 403b Plans are offered by employers. In concept, the plans are essentially identical – the private sector offers 401k plans and the public sector offers 403b plans. For the remainder of this section, we will refer to 401k plans; all of our statements apply equally to 403b plans. An employee enrolled in a Traditional 401k plan contributes before-tax dollars to the plan, and pays no tax on the earnings until funds are withdrawn. At the time the funds are withdrawn they are subject to income tax, at ordinary income tax rates. Thus, the earnings grow tax-free which can have a dramatic effect, as illustrated above. As you would guess, there are a bunch of defining characteristics and restrictions associated with 401k plans. Here are the most important ones:

  • Many employers offer matching funds for employee contributions, up to a maximum level. This match is “free money” – most of the gurus recommend participating in your 401k plan at least to the level that garners the matching funds. We agree.
  • You can roll the funds from your Traditional 401k into an Immediate Annuity at retirement without triggering income taxes. An Immediate Annuity provides you with a stream of payments for the remainder of your life – they are very useful for managing the risks of outliving your money in retirement.
  • The payments from the annuity are fully taxable, but you are deferring the taxes even further. This feature is particularly important for funds that you plan to put into an Immediate Annuity.
  • The maximum amount you can contribute to your 401k is $18,000in 2015 and you can contribute an additional $6,000 if you are 50 years old or older. These limits are indexed for inflation [1].
  • It is almost impossible to withdraw any of your 401k plan funds while you are still working for the company.
  • You may be able to borrow against your 401k funds, but the gurus agree that this is almost always an unwise action. We agree.
  • If you are no longer working for the company and you withdraw funds before you reach age 59 ½, in most circumstances the funds are fully taxable and you are subject to penalties.
  • You must begin withdrawing funds at age 70 ½ [2]. If there are still funds in your 401k at the time of your death, your beneficiaries will be required to take minimum withdrawals according to a schedule.

Roth 401k (and 403b) Plans

Some employers offer Roth 401k plans, which are similar to the traditional 401k plans. With the Roth 401k, the employee contributes after-tax dollars, but then there is no tax on the withdrawals after age 59 ½ if you have held the account for at least 5 years. We think of it this way: the traditional plan is “no tax now, but tax later;” the Roth is “tax now and no tax later.” Is it preferable to pay the tax now, or is it better to pay the tax at withdrawal? Interestingly, if the tax rate now is identical to the tax rate at the time of withdrawal (and assuming the before-tax investment amount is the same, etc.) the Roth and the traditional 401k provide the same return at the end of the day. This interesting (and useful) result can be seen by looking some numbers. Suppose we have $10,000 before tax, and we invest at a 10% rate of return, and our combined Federal and state tax rate is 32%. At the end of 20 years, our total return is:

Traditional: $10,000 x (1 + .10)20 x (1 – .32) = $45,747 [Invest the $10,000 at 10%, then pay 32% tax] Roth: $10,000 x (1 – .32) x (1 + .10)20 = $45,747 [Pay 32% tax on $10,000; invest remainder at 10%]

The only difference between the two equations is the order of the multiplication, so we end up with the same amount either way. The limit on the amount of money you can contribute to your 401k is a combined limit – the sum of your contributions to a traditional and a Roth 401k cannot exceed $18,000 in 2015, or $24,000 if you are 50+ years of age [1]. The Roth 401k plan has the same features as the traditional 401k, which are listed above, but there are a few significant differences:

  • Although the maximum annual contribution you can make to either a Roth or a traditional 401k plan is identical, the Roth amount is after-tax, so you can effectively contribute considerably more to the Roth 401k.
  • The employer match to a Roth 401k is before-tax; the funds are held in a separate Traditional 401k account and are fully taxable at withdrawal. This match of before-tax dollars to the employee’s after-tax contribution, however, means that the employee using a Roth must, in essence, contribute a larger amount to receive the same matching funds.
  • Like the traditional plan, the Roth 401k has mandatory withdrawals beginning at age 70 ½. But, if you are no longer employed at the company, you can roll a Roth 401k into a Roth IRA, which does not have mandatory withdrawals.

As a general matter, we like both Traditional and Roth 401k (and 403b) plans. For both, we particularly like the plans where the employer provides a significant match to the employees’ contributions, and where the employer is diligent in selecting a plan with low costs. In this regard, we understand that there are a few 401k plans (typically offered to very small businesses) where the fees are so high that they vitiate the benefits of the plan. So it would be wise to inquire about the costs of a 401k plan that is offered to you.

Traditional or Roth 401k – Which is Better for You?

If your employer offers both a Traditional and a Roth 401k Plan, you can split your contributions between them. How should you approach the question of which is the best allocation between the two plans?

Let’s start by clearing up a common misperception: you may have read (we have) that contributing to a Roth 401k, compared with contributing to a Traditional 401k, will reduce your take-home pay because you must pay taxes on the Roth contribution. This statement is incorrect. The mistake occurs because of a failure to start at a common point – we need to start at the point where you have decided to allocate some amount of pre-tax dollars to your 401k. Suppose you decide to allocate $10,000 in pre-tax funds. If you contribute to a Traditional 401k, you pay no taxes now on the contribution. If you contribute to a Roth 401k, you use part of the $10,000 to pay the tax on that $10,000 (it’s all part of your taxable income) and you contribute the remainder to the Roth 401k. Yes, you pay more in taxes – but your take-home pay is the same. As we showed above, if your tax rate remains unchanged (and the investment vehicle is the same), you will end up with the same after-tax return whether you use the Roth or the Traditional. To repeat what we showed above, if the combined Federal and state tax rate is 32% and the annual return is 10%, the total return at the end of 20 years is:

Traditional: $10,000 x (1 + .10)20 x (1 – .32) = $45,747 Roth: $10,000 x (1 – .32) x (1 + .10)20 = $45,747

So let’s turn to the factors that DO affect your decision:

  1. Your contribution amount relative to the maximum level matched by your employer. If your contribution of after-tax dollars to a Roth would fall below the maximum level matched by your employer, you would receive more matching funds by contributing the equivalent pre-tax dollars to a Traditional 401k. You will receive more matching funds because the employer matches the contribution amount without considering whether you are paying taxes on your contribution or not.
  2. Your wish to allocate even more to your 401k. Your allocation of pre-tax dollars can be considerably larger if you use the Roth 401k. The limits for Roth and Traditional are the same, but the Roth dollars are after-tax. So, if you wish to allocate more than $18,000 ($24,000 for age 50+) of pre-tax dollars to your 401k in 2015, the Roth will allow you to do so.
  3. Your view about your future tax rate compared to your current tax rate. A view that future tax rates will be higher (or a desire to protect against that possibility) will favor the Roth 401k. A view that your future tax rate will be lower favors the Traditional 401k.

Our View

Our recommended approach depends on the level of before-tax dollars that you plan to allocate to your 401k. We have 3 categories. Is your level:

  • Below the level of contribution receiving the maximum match from your employer, or
  • Between the level for receiving the maximum match and the maximum amount you are allowed to contribute to your 401k, or
  • Above the maximum amount you are allowed to contribute to your 401k?

Here is our advice for each category:

  • Your contribution is below the level for receiving the maximum match from your employer. We really like matching funds. If your allocation of before-tax dollars is below the level for receiving the maximum match, any allocation to the Roth 401k will reduce the amount of matching funds you receive from your employer. So in this category, the benefits of more matching funds usually dominate the other factors, favoring a full allocation to the Traditional 401k.
  • Your contribution is between the level for receiving the maximum match and the maximum amount you are allowed to contribute to your 401k.In this category, some advisors recommend a balanced approach – splitting your allocation between the Roth and the Traditional. We would note that the employer’s contribution is put into a Traditional 401k so you will automatically have some splitting if you receive matching funds. We generally favor the Roth because it removes the risk of encountering significantly higher tax rates later. Our reasoning has two parts:
    1. We’re not very optimistic about future tax rates being lower, and
    2. From an ease-of-mind standpoint, we think removing all worry about future tax rates outweighs the possible increased return we could achieve if tax rates were to fall.

If you decide to allocate some of your contribution to the Roth, we recommend that you first contribute those funds to a Roth IRA up to the maximum you are allowed. The Roth IRA is much more flexible than the 401k – you can choose your own low-cost provider and you can withdraw your contributions at any time.

  • Your desired contribution (of before-tax dollars) is above the maximum amount you are allowed to contribute to your 401k.In this category, our recommendation is to use the Roth because it will allow you to contribute more funds to your 401k. Again, you may consider splitting your allocation between the Roth and the Traditional. But, as we note in part b) above, we generally favor the Roth because of its protection against tax rates being higher when you withdraw the funds. And you will have some splitting as a natural consequence of the employer’s match going into a Traditional 401k.Finally, as we noted in part b) above, a Roth IRA is much more flexible than a Roth 401k. So, if you decide to allocate some of your contribution to the Roth, we recommend that you first contribute those funds to a Roth IRA up to the maximum you are allowed. As you apply these recommendations, it is important remember that we started by focusing on the allocation of before-tax dollars. As a result, planned contributions to the Roth 401k (and to your Roth IRA) must be calculated as the remaining funds after you have allowed for the taxes that will be due on those contributions.

We now turn to tax shields that are not offered through your employer and do not have an employer matching funds feature.

Traditional IRAs (Individual Retirement Accounts) with Pre-Tax Contributions

A traditional IRA with before tax contributions looks very much like a traditional 401k – you invest before-tax dollars, the earnings compound tax-free until withdrawal, and the withdrawals are taxed at ordinary income tax rates. Like the Traditional 401k, a Traditional IRA can be rolled into an Immediate Annuity without triggering immediate taxation. The contribution of before-tax dollars is accomplished by deducting the amount of the IRA contribution from taxable income when you do your tax return. About the only difference between this IRA and the 401k is that the individual sets up the IRA (mutual fund companies, brokerages, and banks are happy to do this for you) and, of course, there is no matching contribution available from your employer. The same kinds of restrictions apply with regard to withdrawals (withdrawals before age 59 ½ usually trigger a 10% penalty in addition to the taxes due, you must begin taking withdrawals at age 70 ½, and beneficiaries must take minimum withdrawals)[2]. Just as we like 401k plans, we like these IRAs as an effective tax shield, although the absence of an employer match diminishes our enthusiasm a bit. On the positive side, you have great flexibility in setting up an IRA; in particular, you can choose a low-cost provider.

Eligibility: To determine whether you are eligible to contribute before-tax dollars to a traditional IRA, look at two areas:

  • If you are NOT a participant in a retirement plan offered by your employer (such as a 401k plan), your IRA contribution to a traditional IRA is fully deductible.
  • If you are a participant in an employer-sponsored retirement plan, your eligibility depends upon your adjusted gross income. For 2015, the cutoff for single taxpayers is $61,000 (with partial deductibility up to $71,000); the cutoff for married taxpayers filing jointly is $98,000 (with partial deductibility up to $118,000).

Amount Limits: In 2015, the maximum amount a person under age 50 can contribute to a Traditional IRA is $5,500; persons age 50 or over can contribute $6,500. These limits are indexed to inflation. Timing of Contributions: You may make contributions any time between the first of the year through April 15 of the following year. In other words, you can make “2015” contributions any time between January 1, 2014 and April 15, 2015.

Roth IRAs

A Roth IRA looks very much like a Roth 401k – you contribute after-tax dollars, but then all of the withdrawals (subject to some restrictions) are tax-free. The Roth IRA has some other attractive features:

  • You can withdraw your contributions at any time
  • If your account has been open for at least 5 years and you are more than 59 ½ years old, you can withdraw the earnings tax-free as well.
  • Unlike traditional IRA accounts (see following section) there are no mandatory withdrawals required from Roth IRAs. If there are still funds in your Roth IRA at the time of your death, however, your beneficiaries will be required to take minimum withdrawals according to a schedule.
  • While the Roth IRA can be converted to an Immediate Annuity, the effective deferment of taxes on earnings does not continue beyond the point of conversion.

The Roth IRA does have some significant restrictions – there are income limitations and limitations on the amount that you can contribute [3].

Income Limits: For 2015, single taxpayers can make a full contribution to a Roth IRA if their adjusted gross income is less than $116,000 (with partial contributions for income less than $131,000), and married taxpayers can make a full contribution if their adjusted gross income is less than $183,000 (with partial contributions for income less than $193,000). These limits are indexed to inflation.

Amount Limits: In 2015, the maximum amount a person under age 50 can contribute to a Roth IRA is $5,500; persons age 50 or over can contribute $6,500. These limits are indexed to inflation. You may notice that these limits are identical to the limits on contributions to a Traditional IRA; in fact, the limit is a combined limit for a Traditional and a Roth IRA.

Timing of Contributions: As with the Traditional IRA, you may make contributions any time between the first of the year through April 15 of the following year.

Roth vs Traditional Pre-Tax IRA

If you qualify for contributing to a Traditional Pre-Tax IRA, you will also qualify for contributing to a Roth IRA. You can contribute to both – the maximum contribution level is for the sum of your contributions to each. How should you allocate your contributions? As we discuss in the comparison of Roth and Traditional 401k plans above, the comparison needs to start at the point where you have decided to allocate some amount of pre-tax dollars to an IRA. As we showed in that section, if tax rates stay unchanged (and the investment is the same), the Roth and the Traditional IRA will provide the same after-tax return when the funds are withdrawn. And there is no employer match here, so that is not a factor in the comparison. The relevant factors are:

  1. Your wish to allocate more than the maximum allowed for the Traditional Pre-Tax IRA. Just as with the 401k plans, the limits for Roth and Traditional are the same, but the Roth dollars are after-tax. So, if you wish to allocate more than $5,500 ($6,500 for age 50+) of pre-tax dollars to your IRA in 2015, the Roth will allow you to do so.
  2. Your plans for using the account to fund an Immediate Annuity when you retire. You can roll the funds from your Traditional IRA into an Immediate Annuity without triggering income taxes. The payments from the annuity are fully taxable, but you are deferring the taxes even further.
  3. Your view about your future tax rate compared to your current tax rate. A view that future tax rates will be higher (or you want to protect against that possibility) will favor the Roth IRA. A view that your future tax rate will be lower favors the Traditional Pre-Tax IRA.
  4. Your desire for flexibility. You can withdraw your contributions from the Roth IRA at any time, whereas withdrawals before age 59 ½ from a Traditional IRA will trigger penalties. Moreover, the Roth has no required distribution at age 70 ½, which provides more flexibility for retirement and estate planning.

Our View

We like the Roth IRA. If you are in the position of comparing these IRAs, it means that you are not contributing to a 401k plan. As a result, we surmise that it is important for you to put as much as you can into the IRA. Since the Roth IRA contributions are after-tax, you can effectively put more “before-tax” dollars into the Roth. We recommend putting as much as you can into a Roth IRA; if your income limits the amount you can contribute to the Roth, we recommend contributing to the Traditional Pre-Tax IRA as well. If you are only able to make a modest contribution to your IRA, we still would give the nod to the Roth. Although the Traditional Pre-Tax IRA has advantages if you use the funds for an annuity, we would give slightly greater weight to the flexibility of the Roth and its protection against higher tax rates in the future.

Traditional IRAs with After-Tax Contributions

If you are ineligible to contribute before-tax dollars to an IRA, you can still contribute after-tax dollars (the contribution is not deductible from your taxes). Again, taxes are deferred until you withdraw funds, at which time you pay taxes on the earnings, at ordinary income tax rates. For tax purposes, a withdrawal comprises two components: principal (tax-free) and earnings (taxable). These components are set according to the corresponding split in the total account. (For example, suppose I have contributed $800 to my account and it has earnings of $200 for a total value of $1,000. If I withdraw $100, $80 will be tax-free and $20 will be taxable.) The After-Tax Traditional IRA has limitations on the amount you can contribute, penalties for early withdrawal, and mandatory withdrawals beginning at age 70½. These limitations are the same as those for the Traditional IRA with Pre-tax Contributions. You can roll the funds from your After-Tax Traditional IRA into an Immediate Annuity without triggering income taxes at the time of the conversion.

Our View

If you are eligible to contribute to a Roth IRA: In this case, we see no reason to consider the After-tax Traditional IRA. The Roth IRA is superior to the After-Tax Traditional IRA – you contribute after-tax dollars to both, but the Roth withdrawals are completely tax-free, whereas you pay the deferred taxes on the earnings with the After-Tax Traditional IRA. If you use the funds to purchase an Immediate Annuity, you are still better off with the Roth. With the Roth, all of the funds that go into the Immediate Annuity is considered principal; with the After-Tax IRA, the earnings are taxable and will be taxed as you receive payments from the Immediate Annuity.

If you cannot contribute to a Roth IRA: In this case, you may wish to contribute to an After-Tax Traditional IRA with the intent to convert it to a Roth IRA. Prior to 2010, there were income limitations that constrained the ability to convert a Traditional IRA to a Roth IRA. Beginning in 2010, the income limitations for conversion expired. So, you can now convert After-Tax Traditional IRA to a Roth IRA. You will incur taxes on the earnings. The 5-year clock for withdrawing earnings from the Roth will start at that time (but you can withdraw the contributions at any time)[4]. If you are thinking about contributing to a Traditional IRA with the intent of converting it quickly to a Roth, we need to add a big word of warning.  In determining the taxes due on an IRA conversion, the converted funds are considered to have been withdrawn proportionately from ALL of your Traditional IRA accounts.  To illustrate, suppose you already have $50,000 in a Traditional IRA where the entire amount is tax-deferred (all your contributions were pre-tax dollars).  You now contribute $5,000 of after-tax dollars to another Traditional IRA, and immediately convert this IRA to a Roth — thinking that you will not incur any taxes.  The IRS will consider your conversion to be drawn from the entire $55,000 you have in Traditional IRAs, of which 90.9% is taxable ($50,000 divided by $55,000).  So you would owe taxes on 90.9% of the $5,000 you convert. We are less enthusiastic about using an After-Tax Traditional IRA as a tax shield without any intention to roll into a Roth IRA. On balance, we tend to favor leaving the investment unshielded rather than putting it in an After-Tax Traditional IRA. Our thinking goes along the points outlined below; one factor favors the IRA and the other factors favor keeping the investment in an unsheltered account. The factor that favors the After-Tax Traditional IRA is the ability, at retirement, to roll the accumulated funds from the IRA into an Immediate Annuity without incurring taxes. If you wish to convert funds from an unsheltered account into an Immediate Annuity, you will have to pay taxes on any accumulated capital gains. On the other hand, there are several factors that favor leaving the investment in an unsheltered account: There is a significant difference in tax consequences if you die before you withdraw the funds. With an unsheltered account, there is a step-up in basis, so taxes on any capital gains are avoided. With the IRA (as with all IRAs) there is no step-up in basis.

  1. The earnings from an After-Tax Traditional IRA are deferred, but they are then taxed at ordinary rates. If your investment is expected to generate returns that are eligible for capital gains tax treatment, you are likely to be better off if you leave the investment unshielded rather than putting it inside an After-Tax Traditional IRA. Whether you are better or worse off depends on several parameters – the tax rates, the gross return rate, the percentage of the gross return that receives capital gains treatment, and the time period. In our calculations, we find that the unshielded investment usually does better than the After-Tax Traditional IRA.
  2. Even if your investment is expected to generate annual earnings that are subject to ordinary income tax, the benefits seem muted. True, your total return will be enhanced somewhat by deferring taxes (if the tax rate remains unchanged). But, if you have a moderate time horizon and are using an After-Tax Traditional IRA for low-yielding assets, the boost from the tax deferment is modest.
  3. The After-Tax IRA reduces your flexibility. If the funds are in an After-Tax Traditional IRA, any withdrawals before age 59 ½ will likely trigger penalties. If you keep the assets outside a tax shelter, no such penalties apply. Thus, to the extent you want to consider these assets as part of your liquidity, using the IRA is considerably less useful.

Our View – Conclusion

When we look at all the factors, we find it difficult to generate much enthusiasm for the After-Tax Traditional IRA, except for those who wish to contribute to a Roth IRA but are precluded from doing so by the income limits.  For those people, the After-Tax Traditional IRA offers a “back door” way to contribute to a Roth IRA by first contributing to the Traditional IRA and then converting to a Roth.  Except for that purpose, we do not think the After-Tax IRA offers significant advantages compared with keeping the investment in an unsheltered account. We now turn to some tax shelters that are offered by the life insurance industry.

Tax Deferred Annuities (TDAs)

TDAs are investment vehicles, provided by life insurance companies, that are essentially the same as After-Tax IRAs. TDAs have other names, such as variable rate annuities. We refer to any annuity where the prominent feature is the deferment of taxes on the earnings as a TDA. TDAs are related to, but differ from Immediate Annuities – TDAs are used for investing, while Immediate Annuities are used to provide you with a stream of payments for the remainder of your life[5]. Here are the major features of the TDA:

  1. You contribute after-tax dollars
  2. You pay no taxes on the earnings until the funds are withdrawn
  3. The tax rate on the earnings at withdrawal is the rate for ordinary income
  4. Withdrawals before age 59 ½ generally trigger penalties
  5. Mandatory minimum distributions begin at age 70 ½.
  6. A TDA can be converted into an Immediate Annuity without incurring taxes at the time of conversion.

Being so similar to the After-Tax IRAs, the TDAs have the same disadvantages compared with putting your investment into an unsheltered account.

  1. There is no step-up in basis with the TDA
  2. The earnings from the TDA are taxed at ordinary rates.
  3. The TDA reduces your flexibility –funds in a TDA are subject to penalties if you withdraw them before age 59 ½.

Worse, fees for TDAs have historically been rather high. Part of the reason for these higher fees is due to the linkage of TDAs to life insurance – the TDA must include some component of life insurance in order to qualify for the deferment of taxes. Usually this insurance component is designed with a view to minimize costs. Put differently, the product typically includes a life insurance feature with minimal benefit in order to avoid increasing the cost of the product. As a result, you pay for something that typically isn’t very valuable to you. To illustrate, a common TDA benefit is to guarantee that if the investor dies, the TDA will pay the beneficiary an amount that is no less than the amount the holder had contributed. In order to benefit from this provision, however, you have to a) die, and b) die at a time when the value of your investments has dipped below the total of your contributions. This combination is reasonably unlikely for workers who are saving for retirement. Nonetheless, this insurance costs a “little bit” and, as we have shown earlier, “small” additional costs have a significant impact over a long period of time. Another reason for the typically high fees is that these products have usually carried high sales costs. As we have discussed earlier, high sales cost represent a dead-weight drag on your returns – we are unaware of any studies showing that higher sales costs are associated with higher returns.

Our View

We have not been enthusiastic about TDAs. The older versions are almost identical to After-Tax IRAs. And, as noted above, we are generally unenthusiastic about After-Tax IRAs. With their higher costs, these TDAs seem even less attractive. Having said that, we would note that in recent years some providers have offered TDAs with lower administrative costs, and have included features that are more attractive.  Our difficulty with some of these newer TDAs is that the features seem too attractive: we have been unable to figure out how the companies can offer those products at a profit.  We like deals where we can see how both sides benefit.  So stay tuned to this area – we will continue our investigation and report our findings.

Cash Value Life Insurance Policies

Cash Value Life Insurance combines death insurance with a tax-deferred savings plan [6]. The concept seems sound – many people need both insurance against death and also need to save for retirement. Unfortunately, the expenses of Cash Value Life Insurance tend to be high, without commensurately higher returns. Most wealth management gurus recommend that you pursue these goals with separate products – buy term life insurance and invest funds for retirement separately. We would note that Cash Value Life Insurance may be useful for estate planning.  In 2015, estates of less than $5.43 million are exempt from taxes.  If you expect your estate to be large enough to need protection from estate taxes, Cash Value Life Insurance may be useful to you.

Our View

We agree with the gurus – buy term life insurance for your life insurance needs, and manage your investment funds separately.

Education Savings Plans

Two of the most useful tax shields for education savings are 529 plans and Coverdell Education Savings Accounts.

529 Plans. If you wish to invest money to pay college or graduate school expenses, a 529 Plan offers some attractive features:

  1. You can contribute up to $14,000 per beneficiary per year; alternatively, you can make 5 years of contributions at once (5 x $14,000 = $70,000 total)
  2. Earnings are tax-free if the withdrawals are used for post-secondary education.
  3. In the College Savings Iowa Plan, contributions up to $3,163 per beneficiary are deductible from Iowa state income taxes for 2015. Spouses can each contribute $3,163 to a single beneficiary and receive a combined $6,196 deduction on their joint Iowa State tax return [7].  Or put another way, a married couple with two children contributing to separate accounts can deduct up to $12,652 (that’s 4 x $3,163) in 2015.

Coverdell Education Savings Accounts. These plans were established before the 529 and have quite similar features – you contribute after-tax dollars and then the withdrawals for educational purposes are tax-free [8]. The major differences with the 529 plans are:

  1. The withdrawals are tax-free for K-12 educational expenses as well as college and post-graduate.
  2. Unlike the Iowa 529 Plan, there is no deduction from state income taxes.
  3. Annual contributions are limited to $2,000 per child
  4. There are income limitations – for 2015 single filers may contribute the full amount if their AGI is less than $95,000 (with partial contributions if AGI is less than $110,000), and joint filers may contribute the full amount if their AGI is less than $190,000 (with partial contributions if AGI is less than $220,000).

Our View

For post-secondary education expenses, we recommend using the Iowa 529 Plan to the extent that you are eligible. It is administered by Vanguard and has reasonably low costs. And you can take a deduction from your Iowa state taxes. A word of caution about investing for education expenses: be sure to invest in assets that are appropriate for your time horizon. In the Asset Allocation section of Basic Principles, we expressed our view that stocks and real estate are inappropriate investments if you have a short or moderate time horizon.


References

  1. 401(k) Resource Guide – Plan Participants – Limitation on Elective Deferrals (Apr. 2, 2014). IRS, http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/Retirement-Topics—401(k)-and-Profit-Sharing-Plan-Contribution-Limits 
  2. 401(k) Resource Guide – Plan Participants – General Distribution Rules (Apr. 2, 2014). IRS, http://www.irs.gov/Retirement-Plans/Plan-Participant,-Employee/401(k)-Resource-Guide—Plan-Participants—General-Distribution-Rules
  3. Publication 590 (2013) Individual Retirement Arrangements (2014). IRS, http://www.irs.gov/publications/p590/ar01.html#en_US_2013_publink1000254864
  4. Greene, K. (June 20, 2009). Making a Good Deal for Retirement Even Better. The Wall Street Journal Online, http://online.wsj.com/article/SB10001424052970204612504574193480955034164.html
  5. Your Guide to Tax-Deferred Annuities or Voluntary Savings Plans. TIAA-CREF, https://www.tiaa-cref.org/public/pdf/pdf/your-guide-to-tax-deferred-annuities.pdf
  6. Merkel, S. Personal Finance – Insurance. Buying Life Insurance: Term vs. Permanent. NASDAQ, http://www.nasdaq.com/personal-finance/buying-life-insurance.stm
  7. College Savings Iowa Plan (529 Plan), https://www.collegesavingsiowa.com/content/taxbenefits.html
  8. Coverdell Education Savings Accounts. IRS, http://www.irs.gov/newsroom/article/0,,id=107636,00.html