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  • Barry Boscoe

Retirement Planning


Vol. 17 No. 19 Reprinted by permission of the Los Angeles Business Journal ™

Good Retirement Planning Requires Staying Abreast of Changes in Laws by Barry Boscoe, CFP The cornerstone for investment building has been the traditional retirement plan. However, the federal government has decided to reduce these planning benefits for individuals. Since the mid-1970s, the government has changed the tax laws relating to retirement benefits on an average of at least once per year, which has led to a dramatic decrease in the amount of retirement benefits for which an individual can save. The format for retirement planning will be significantly different in the 1990s. This change is a result of two powerful trends that have gained momentum and, over time, will continue to shape the dynamics of retirement planning. The first trend is the certainty of higher taxes. The second is the increase of restrictions in the use of traditional retirement plans. One change in qualified retirement plans is the reduction of the maximum deductible deferral. IRAs have been nearly phased out for those making too much money. The ability to skew benefits in favor of the owner is becoming more difficult for employee-sponsored plans. Worst of all, penalties are now levied against those who retire early with too much money. As a result, in the last four to six years there has been a major reduction in the number of qualified retirement plans, as well as a decrease in the number of new plans. Many employers, physicians and professionals are exploring new and creative ways of planning for their retirement. The first step in taking advantage of tax-favored vehicles is a look at the four different methods available for accumulating wealth: taxable, tax-deductible, tax-deferred and tax-free. We will explore tax-deductible and tax-free, the two methods that are most commonly used. Under a tax-deductible vehicle, deductions are taken on the front-end when the contributions are made. These plans are typically non-discriminatory and, because of their tax nature, have many restrictions. A tax-free vehicle is funded on an after-tax basis, but the income is received within a tax-free environment. Both vehicles accumulate tax-deferred. The most popular tax-deductible vehicles are qualified retirement plans, including IRAs, 401(k) plans and profit-sharing plans. Tax-free vehicles, also known as non-qualified retirement plans, are typically funded within an insurance product that has an investment orientation. Both of these vehicles allow for investments in stocks, bonds (international and foreign), real estate, natural resources and cash. Let’s look at a retirement planning example: John operates a small, very profitable manufacturer’s rep business. He earns $150,000 per year and has three employees, who together earn a total of $65,000. John is in the 36 percent tax bracket and currently contributes the maximum 15 percent to his profit-sharing plan. John also contributes 15 percent on behalf of his three employees, for an additional cost of $9,750. Because of the highly technical nature of qualified retirement plans, administrative expenses cost John an additional $1,400 per year, for a total cost of $33,650. However, John does have the benefit of taking a deduction and thereby saves $11,441 in taxes, bringing the net cost for his plan to $22,209 per year. John is 45 years old and wishes to retire in 20 years. He currently has a $1 million, 20-year level term insurance that costs $1,350 per year, bringing his total net out-of-pocket cost for both his retirement plan and insurance protection to $23,559. John has a neighbor, Bill, who also owns a very profitable business with three employees. However, Bill has been advised by his attorney and financial adviser that he would be better off installing a non-qualified retirement plan. Bill wishes to benefit primarily himself – he does not want to incur any of the costs or potential problems associated with involving his employees. Bill has arranged through his financial adviser to purchase and fund a non-qualified retirement plan on his behalf for about $23,00 per year for the next 20 years. He has told his adviser that he desires the flexibility to invest in real estate, stocks, bonds and cash. In addition, he would like to withdraw money at any time during the 20 years he is planning to save without incurring any penalties or taxes. Both Bill and John have projected that they will receive their retirement income for 15 years between the ages of 65 and 80, their approximate life expectancy. At that time, they would like to have money left over to fund whatever estate taxes might be invoked. Through careful investment planning, John has assumed that he will be able to earn 10 percent per year on the money he will be contributing to his plan. At the end of the 20 year period, when John reaches age 65 and retires, he will have accumulated $1,417,550. Using this money, John will be able to retire on an after-tax income of $98,140, assuming he continues to earn at least 8 percent per year. At age 80, John will have exhausted his funds. Upon his death, there will be little or no money left for his heirs or estate taxes. The term insurance that John purchased will probably be terminated after age 65. Statistically, less than 5 percent of term insurance remains in effect beyond age 65, and by age 70, almost all term insurance is terminated because of the prohibitive cost of maintaining the death benefit. Bill, on the other hand, who is also earning 10 percent on his portfolio, will have $1,047,000 available for retirement. He will be able to withdraw $105,491 on an after-tax basis until age 80. At age 80, Bill will still have $294,000 in reserve, as well as a death benefit of $388,000 that can be used to pay estate taxes or be left to his heirs. The total amount of money that Bill and his family will receive will be $1,970,000. In John’s case, the total amount received will be only $1,472,000, a difference of almost $500,000. The difference between the two approaches is that the non-qualified retirement plan provides greater benefits even though it does include an immediate tax deduction. In an increasingly restrictive tax environment, the results and benefits provided by the non-qualified plan will be significantly greater. Deductions will be taken in a lower tax environment and distributions made in a higher tax environment. Non-qualified plans are not new – they have been used by more than 85 percent of the Fortune 500 companies, primarily for their highly compensated executives. The flexibility provided by these programs allows for unlimited contributions. Deposits can be made either by the business or the individual. Money accumulated tax-deferred may be invested in all forms of marketable securities. Account values are accessible during the working years, and in some court jurisdictions, are fully protected against the claims of creditors. Lastly, death benefits are income tax free and provide a greater amount of money than any other form of retirement plan. Even with all these advantages, it is surprising how much time individuals spend searching for the right investment vehicle instead of trying to find the best tax retirement vehicle. Even more surprising is the effort spent in determining the right type of insurance, when it is possible to purchase the insurance within the non-qualified retirement plan for the same costs as buying it outside the plan. It is critical for individuals to concentrate not only on investments, but also on the tax aspects of retirement planning. Higher taxes and greater restrictions will continue to reduce retirement benefits if the traditional approach to investment planning is used. Adapting to the ever-changing tax environment is a wise and profitable strategy for individuals planning for their retirement.

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