I have heard a lot of radio ads for various shows and products where they like to brag how you can live on the “tax free side of life”. Perhaps you’ve heard them too. If this really possible? Or are they selling a bunch of malarkey?
Let’s dig in and find out. If you’ve read some of my past entries from here, you’ll surely have noticed me talking about things like EIULs, real estate, and MLP stocks and their tax advantages. In this article, I want to look at how EIULs operate compared to a 401K in the arena of taxes.
Now before we go any further, I want to make one thing clear.
There ain’t no such thing as a free lunch, especially in taxes.
When you dig in and see how various investments operate, it’s more about picking the best, most efficient tax strategy that will serve your needs. Since this blog is about building retirement wealth, I generally talk about the best tax strategy for your retirement.
401K taxes vs. EIUL taxes
That sounds pretty vague, ehh? Let’s use a concrete example: 401K taxes vs. EIUL taxes.
If you use your company’s 401K plan, you get the nice benefit of writing off your contributions. You don’t have have to pay a nickel in taxes for every dollar you stuff into your plan…today. The trade off? (There’s always a trade off). When you start making withdrawals, you will be subject to full income tax rates on every dollar you take out.
Many people are drawn to the allure of avoiding taxes today. It sounds great to take home more pay. I certainly liked the sound of that when I got started at my first job. The problem was, there was no one there to coach on the options and benefits of other vehicles by which I could pay taxes today and pay considerably less in retirement. As the saying goes, you don’t know what you don’t know.
If you buy an EIUL instead, you fund it with after tax dollars. Every dollar that goes in has a certain amount skimmed off for Uncle Sam based on your income. Then when you decide to withdraw money later on in retirement, you do so tax free. The trade off is that by paying taxes up front, you can skip paying taxes in retirement.
Which is better? Well from a tax perspective alone, I prefer the EIUL for two reasons.
- The total amount of taxes I pay will smaller, because the total money in action is smaller. In general, as I get older, I make more money, and pay more taxes. So the sooner I can move that money off the tax rolls, the better.
- Tax rates and policies are always moving around and the subject of elections. What will this country’s entire tax structure be like in twenty or thirty years? Who knows. I’m still waiting for my crystal ball to get out of the shop. Until that time, I’ve decided that I don’t want to gamble my retirement on such a huge unknown.
If you’ve read this blog, then you know I also advocate EIULs due to better and more consistent historical performance, but I’m leaving that aspect out of this article. For tax purposes alone, it’s generally better to pay up front than later on in life. (But this never precludes doing a complete analysis!)
The tax man cometh
I’ve run into people that don’t understand why EIULs let you “get away with dodging taxes.” Some of these people I’ve chatted with tend to believe any chunk of cash you receive should be subject to income taxes.
For starters, any time you start making withdrawals from your EIUL, the first batch of money is considered return of capital. Essentially, whatever money was put into your cash value holdings is simply being handed back to you. And as pointed out earlier, you already paid taxes on it. Is it really fair to tax you twice on money that effectively didn’t go anywhere?
After you get your premiums back, then you begin taking out loans against the cash value left. Loans are non-taxable events. For my friends that believe this is trickery, I wonder if they are ready to pay income taxes every time they finance a car. If you borrow $200,000 to buy a house, do you think you should suddenly be hit up with a $48,000 tax bill that year? And what about using your credit card? Every time you use it, you are borrowing money to buy something. Should that also be taxed?
I’m sure you don’t want to pay taxes on any of that debt, but what’s the underlying reason you shouldn’t? Because you will ultimately pay off your debt using taxable dollars. The government WILL get their cut of money based on this debt. They just get it in smaller chunks. Bought a $20,000 car? You will end up paying it off with $20,000 of hard earned money subject to good ole’ income tax laws. In fact, thanks to financing, you might actually be shelling out a little bit more, all paid with taxable dollars.
But wait! EIUL loans aren’t paid off!!! How can you justify THAT?!?
An EIUL is a life insurance contract. The amount of money you pass on to your heirs is tax free. It is an enticement by the government to leave something to support your family, friends, or whomever you wish. When you take out loans, the loans+interest are paid off by the death benefit. And don’t forget: it was funded with after tax dollars.
So as I wrote early on, there is no free lunch. You aren’t “getting away” with anything. You funded a plan with taxable money and structured things so that you could pay the taxes now instead of in retirement.