Scientists have been saying for years that the next big earthquake is due to hit California. Although we are not able to pinpoint when it's going to happen or how bad it's going to be, just having this knowledge allows us to plan appropriately to minimize our losses when it does.
The same analogy can be applied to both the stock market and taxes. In this episode of Money Script Monday, Brian introduces a financial vehicle that is designed to shelter income from stock market volatility and increases in taxes.
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Hi. Welcome to another episode of Money Script Monday. My name is Brian Manderscheid.
Today, I want to teach you how to protect a portion of your retirement from stock market losses and taxes.
Here in Southern California, the scientists had been saying for years that the next big one is coming, the next big earthquake.
We don't know when it's going to happen or how bad it's going to be, but we know at some point it's going to happen.
Knowing this, this allows us to plan appropriately to minimize the losses when the next big one occurs.
We can apply the same analogy to both the stock market and tax rate increases.
Recently, economists, banks, investment firms have been saying that we're on the verge of the next big recession.
Again, we don't know when it's going to happen or how bad it's going to be but it's going to happen at some future point in time.
We also have a government that is just spending trillions of dollars a year and our debt keeps ratcheting it up and we have trillions of dollars of unfunded liabilities.
We don't know how bad it's going to be or when it's going to happen.
But at some future point in time, we will have tax rate increases whether that's wealth taxes, income tax rate increases or state tax increases.
These tax rate increases will most likely be for the wealthy.
Knowing this, that we're on the verge of the next recession, our tax rates in the future most likely will be higher, we can plan appropriately by taking measures today to put our money in vehicles that don't suffer stock market losses and are exempt from taxation.
Today, what I want to talk about is the power of indexing, using the IRS code to your advantage, and lastly, indexed universal life.
The Power of Indexing
First, the power of indexing. A bear market is defined as a major stock market index going down by 20% or greater.
Now, if we go back all the way to the Great Depression in 1929 and look at history, a bear market occurs roughly every five years.
Currently, we're in a 10-year bull market. Again, we don't know when this bull market will end and when we'll have a bear market, but we're based on history way overdue.
The average decline of the bear market since 1929 is almost 40%, so they definitely have big stock market losses.
The average duration from the top to the bottom is a year and a half. Most importantly, the average time to break even is just over five years.
If you have a $100,000 prior to a bear market, it's going to take you 5.2 years to get your $100,000 back after the stock market loss.
So again, we don't know when the next bear market will happen, but we can take measures today to protect against the next recession.
We can do so using a concept called indexing.
Now with indexing, you're not directly invested in the stock market. Instead, your returns are based on an underlying index like the S&P 500, for example.
However, you're going to have two tradeoffs.
One is going to be, you're going to have an upside on your growth, which is going to be something like cap rate, participation rate or spread.
The other tradeoff for having less a return potential is at 0% floor to protect against the downside.
Essentially with indexing, you're able to participate in the stock market returns up to a limiting factor while eliminating the downside loss.
Essentially, your account will only go up or sideways and never down, with the exception of the monthly mortality, expense, and administration fees.
This is a way to hedge against future bear markets.
Using IRS Code to Your Advantage
So next, how do you use the IRS code to your advantage?
There are three basic types of accounts you could put your money in when planning for retirement: taxable account, a tax deferred account, and a tax free account.
Each of these have their own pros and cons and it's important to use them appropriately.
A taxable account, things like savings accounts, CDs, money markets are great for liquidity.
Generally, you want to have three to six months of living expenses in your taxable bucket for liquid emergencies.
That's the benefit is liquidity.
The downside is you can get taxed every year on the growth earned and your growth prospects are low because these are generally shorter-term vehicles.
Once you filled up your taxable bucket with three to six months of expenses, you want to move down the road to a tax-deferred account.
Think of a tax-deferred account as a qualified plan, like a 401(k) through work or an IRA.
The benefit of a tax-deferred account is you have the immediate gratification of the tax postponement or tax deferral lowering your income tax base.
You're going to pay less taxes today but you're going to postpone those dollars and all growth in those dollars to some future point in time when actually tax rates may be higher, the same, or lower.
The downside, con, of a tax-deferred account is we don't know our future tax rates are going to be.
If right now you take the tax postponement in a period of time where tax rates are actually really low compared to history, you may be paying taxes at a later date that are much higher than you pay today.
While tax-deferred accounts are still great if you, let's say fund up to your employer match or max it out if you're a high-income earner, after you've done that, the next best place to put your money to hedge against future tax rate increases is the tax-free bucket.
The tax-free bucket, these would be things like a Roth IRA, Roth 401(k).
With a Roth IRA, if you make too much money, you're actually exempt from contributing.
Also, if your employer doesn't offer a Roth 401(k), you don't have that option available.
Both those options also have strict IRS contribution limits, so you actually are limited to how much you can contribute into those vehicles.
We also have municipal bonds and 529s in the tax-free bucket. However, they're not always tax-free.
Municipal bonds count as provisional income which could affect your social security taxation down the road and also trigger capital gains when sold.
529s are only tax-free when used for qualifying educational expenses.
If you make too much money or you want to contribute more than the IRS limits on a Roth IRA or Roth 401(k), the next best place to put your money is cash value life insurance.
I'll talk specifically about the type of insurance next that we'd recommend.
We talked about indexing using your IRS code to your advantage, that vehicle we'd recommend is index universal life.
Indexed Universal Life
The reason we'd recommend an IUL policy over other cash value life insurance policies is because it provides the power of indexing, it gives us the ability to earn stock market-based returns, usually 60%, 80% of the stock market with the limiting factor, and also have the downside floor.
We also have all of the tax favor treatment that the IRS has been bestowed upon cash value life insurance.
That would be tax-deferred growth, tax-free access when designed properly as a non-modified endowment contract and an income-tax-free death benefit for your family, maybe your business, or favorite charity.
Some IUL policies will also have death benefit accelerations that allow you to live off your death benefit while living, for triggering events like a terminal illness, chronic illness, critical illness, and injury.
Those are some of the benefits of an IUL.
As I mentioned, every vehicle has its own pros and cons.
The downsides of an IUL policy is this is a life insurance policy and they have life insurance fees to fund the life insurance death benefit for your family.
Additionally, the life insurance policy costs are generally front-loaded usually within the first 5 or 10 years of the contract.
It may not have the best early growth and instead most of your earnings are going to be made after 5 or 10 years after you get out of that front-loaded expense period.
Additionally, the biggest con, in my opinion, is they can be set up incorrectly.
We recommend you always buy the least amount of death benefit that the IRS will allow while also funding right up to the maximum IRS guidelines, to buy the policy max efficient.
The reason being if you set up the policy this way, majority of your premiums will go to cash value and only a small portion goes to the life insurance expenses.
Believe it or not, there're agents out there that'll actually buy more death benefit than the minimum, which will increase your life insurance expenses, increase those front-loaded expenses, and also increase their commission.
It's important to work with a qualified advisor to set up an IUL policy correctly in your interest not necessarily in the agent's interest.
Lastly, they do require both medical and financial underwriting so you actually have to qualify to buy this vehicle.
Now if you're unhealthy or you have no need for insurance, this may not be the best option for you.
To start off this video, I mentioned preparing for stock market losses and taxes is a lot like preparing for the next big earthquake.
If you believe that we're going to hit a recession, whether immediately or down the road, and also are a high-income earner and are worried about future tax rate increases.
It's important to tax and risk diversify your portfolio by putting a portion of your money in an index universal life insurance policy to hedge against both income taxes and stock market losses.
Thank you very much. We'll see you next time.
The information presented here is not specific to any individual's personal circumstances. These videos are provided for general information and educational purposes based upon publicly available information from sources believed to be reliable—we cannot assure the accuracy or completeness of these materials or may change at any time and without notice. To the extent that this material concerns tax matters, it is not intended or written to be used, and cannot be used, by a taxpayer for the purpose of avoiding penalties that may be imposed by law. Each taxpayer should seek independent advice from a tax professional based on his or her individual circumstance.
S&P 500 is an unmanaged index of the shares of 500 widely held, predominantly large capitalization, U.S. exchange-listed common stocks. The index results neither include dividends reinvested nor reflect fees and expenses. Investors cannot invest in any index directly. Guarantees provided by insurance products are backed by the claims paying ability of the issuing carrier.
Investment advisory services offered through LifePro Asset Management, LLC, a registered investment adviser. Investments involve risk and are not guaranteed. Different types of investments involve varying degrees of risk, and there can be no assurance that the future performance of any specific investment or investment strategy will be profitable or equal any historical performance.