Tax Planning in Today’s Economic Environment

Talking over tax-free income options with Layman Lewis Financial Group

As you plan for retirement, you face choices as to how you invest your money. When you are trying to decide how to invest your money, start with figuring out why you're investing.

If you're investing primarily to create a comfortable retirement, you'll want to choose investments that will one day help optimize your retirement income. Part of optimizing means planning to deal with taxes. 

If you believe tax rates will only increase, one potential strategy is to invest in currently taxed assets to avoid future tax liability. Or you may want to look into potentially tax-free income options such as life insurance, a Roth IRA, or municipal bonds. Keep in mind, though, that certain tax advantages often come at a cost. 

All else being equal, tax-free money is the best type of income. There are three main types of investments that produce tax-free income: 

1. Municipal bonds 

2. Roth IRAs 

3. Life insurance held until death 

While paying no tax on income is obviously better than the alternative, it comes at a cost, which may reduce or negate its benefits. 

Municipal Bonds 

Municipal bonds are debt obligations issued by a federal, state, or local government. When you invest in a municipal bond, you are essentially loaning the governmental entity money in exchange for a set amount of interest to be paid over a predetermined period. At the end of the term, the full amount that you invested is returned to you. Interest earned from an investment is usually subject to ordinary income tax rates, but under the current rules, interest paid on municipal bonds is generally tax-exempt if the bonds are used to fund governmental projects constructed for the public good. The federal taxation of municipal bonds is complex. 

To add to the complexity, each state has its own laws governing municipal bonds. However, most states do not tax individuals on the interest arising from municipal bonds issued by that state.

What are the problems with municipal bonds? First, municipal bonds generally pay a lower interest rate than other investment options. Second, tax-free income from municipal bonds can also affect your Social Security benefits. This is because such interest is added back to the equation for determining your modified adjusted gross income (MAGI) for Social Security. This could push your income levels high enough to expose your benefits to taxation. 

Bond obligations are subject to the financial strength of the bond issuer and its ability to pay. Before investing, consult your financial professional to understand the risks involved with purchasing bonds. 

Roth IRAs 

Investing in a Roth IRA can be another powerful tool to avoid income taxes on its growth. To fully understand the costs and benefits of investing in a Roth IRA, you need to know how they differ from traditional IRAs. 

Here's the main difference: When you earn income and contribute to a traditional IRA, you don't currently pay taxes on that income. However, when you withdraw money from the traditional IRA, you will incur income taxes on the full amount that you withdraw. 

Conversely, when you earn income and contribute to a Roth IRA, you are still required to pay taxes on that income. On the other hand, when you take money out of the Roth IRA, you generally do not incur any income taxes on that amount, assuming the account has been open for at least five years, and you are over age 59. 

Simply put, traditional IRAs grow tax-deferred while Roth IRAs grow tax-free.

Life Insurance 

Finally, life insurance proceeds also provide an option to receive money tax-free. Life insurance  comes in two main forms: 

1. Term life insurance 

2. Permanent life insurance 

When most people hear about life insurance, the first thing they usually think of is term life insurance, where you enter into a contract that provides a certain death benefit that will go to your heirs upon your death. In exchange for this possible death benefit, you must pay predetermined monthly premiums for a predetermined term - usually 10 or 20 years. If you don't die within the term, you won't receive anything from the policy. 

On the other hand, as long as sufficient premiums are paid, permanent life insurance will pay a death benefit. Because a death benefit will ultimately be paid, premiums under such policies are generally higher than term insurance contracts. However, as you make payments, the death benefit of the policy may increase. 

If the life insurance policy is a non-modified endowment contract (non-MEC), you are generally allowed to withdraw funds from the cash accumulation value tax-free up to the amount you have contributed into it.

If the policy is a modified endowment contract (MEC), withdrawals and policy loans are fully taxable as income to the extent that there is a gain in the policy over the amount of net premiums paid. Taxable distributions are also subject to a 10% federal tax penalty if the owner is below age 59 1/2. 

One downside to planning for retirement with a life insurance contract is that the tax advantages are generally not available until your death. However, if the policy is a non-MEC, you may be able to borrow from the cash value throughout your life without incurring income taxes as long as the insurance contract is still in force. 

Insurance products are offered through the insurance business Layman Lewis Financial Group. Layman Lewis Financial Group is also an Investment Advisory practice that offers products and services through AE Wealth Management, LLC (AEWM), a Registered Investment Advisor. AEWM does not offer insurance products. The insurance products offered by Layman Lewis Financial Group are not subject to Investment Advisor requirements. Investing involves risk, including the potential loss of principal. Neither the firm nor its agents or representatives may give tax or legal advice. Individuals should consult with a qualified professional for guidance before making any purchasing decisions. Layman Lewis Financial Group is not affiliated with the U.S. government or any governmental agency. 2266676 - 02/24

"Tax-free money is the best type of income. There are three main types of investments that produce tax-free income." - Linas Sudzius 

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