Tax-Free Retirements: Fact or Fiction?

Preparing for retirement is a stressful and time-consuming process. You’ll need to manage your assets and income in a way that allows you to preserve your principal while still generating enough consistent cash to cover all your basic living expenses.
One of the biggest challenges for upcoming retirees is finding a way to manage taxes. Generally, you’re going to owe taxes on money you make through investing, but with the right financial planning strategy, you may be able to avoid some—or all—of these taxes.
Is a truly tax-free retirement something achievable? Or is it more of a fantasy?

Taxes on Investments: A Primer

We’ll start this discussion by looking at how taxes work on investments in the general sense. Depending on what you’re investing in and how you’re investing, you’re almost always going to owe taxes on any money that you make whether you’re retired or not.
For example, if you hold stocks for more than a year, you’ll be subjected to what’s known as a long-term capital gains tax; if you invested $10,000 and sold your stocks a year later for $20,000, you would have $10,000 of investment income that would be subject to taxes.
There are some ways for retirees to get around these taxes, such as using strategic losses to reduce the amount of money they owe (since you can write off certain losses). However, if you’re planning for retirement, you may need a more thorough tax planning strategy.

Are you ready to choose a financial advisor to help you plan for retirement? Make sure you know what to look for.

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What Is a Tax-Free Retirement Account?

There are certain types of specialized accounts you can hold to give yourself tax advantages in retirement. Among these include Individual Retirement Accounts (IRAs) and the classic 401(k). Some of these accounts are tax deferred, while others are considered tax-exempt.
For example, a traditional 401(k) plan is considered a tax deferred plan. When enrolled in this type of account, your contributions will be automatically deducted from your paycheck—specifically from your pretax income.
You avoid taxes on your income initially, but you will owe taxes on the money you withdraw in retirement, assuming you made gains on your investments.
IRAs come in a few different forms, and they work somewhat differently. For example, in a Roth IRA, you’ll be investing after tax dollars, so you won’t have the pretax advantage of a 401(k) plan. However, this plan is tax exempt, so you can withdraw your money once you reach retirement age without having to pay taxes on the gains.
You can also choose to enroll in what’s known as a tax-free retirement account (TFRA) which is neither an IRA nor a 401(k) plan. Instead, it’s a type of investment vehicle as outlined in section 7702 of the Internal Revenue Code. Working with a wealth manager or financial advisor, you can invest money and save for retirement through this plan, setting yourself up for tax-free income whenever you retire.
Technically, this account is a permanent cash value life insurance policy. You’ll fund this account after tax dollars, the same way you might fund a Roth IRA. Over time, given proper investment, the value of your cash should increase as you approach retirement. There’s no early withdrawal penalty associated with this type of account, and any income you generate through the plan is not going to be taxed. You’re also free to invest in this type of account even if you have other retirement accounts in place.

Tax-Free Retirement Account Qualifications

Setting up a tax-free retirement account isn’t something you can do by yourself, since there are specific guidelines you need to follow according to section 7702 of the IRC. If you’re interested in starting this type of account, your best bet is talking to a financial advisor specializing in wealth management. A wealth advisor will be able to educate you on the advantages and disadvantages of this type of account and, if you’re still interested in moving forward, set you up with one.

Pros and Cons of Tax-Free Retirement Accounts (TFRAs)

Almost all investment and retirement strategies are imperfect, offering both strengths and weaknesses. You’ll need to consider these pros and cons carefully when determining whether this is an appropriate investment vehicle for your needs.
These are some of the most prominent advantages:

These are some of the most prominent advantages:

  • Tax-Free Income: Most people love the idea of a TFRA because of the prospect of tax-free income. Rather than having to pay the government for money you made through your investments, you can keep all the gains for yourself.
  • No Penalties: Unlike a 401(k) plan or Roth IRA, there are no penalties for early withdrawal. If you need the money, you can get the money at any time with no drawbacks.
  • High Liquidity: Tax-free retirement accounts are highly liquid, so you can get cash quickly and easily on your terms.
  • Consistent Returns: Stable income is a high priority for retirees—and TFRAs provide it.

These are some of the disadvantages:

  • Premiums: Remember, this is technically a permanent cash value life insurance policy. Like with any life insurance policy, you’re going to owe premiums. While these premiums are reasonable, they can eat into your investment funds, so you’ll need to keep them in mind when calculating the value of this approach.
  • Fees: As with most other investment strategies, you’re also going to owe at least some fees, such as management fees. Make sure you fully understand the fee structure in place before moving forward.
  • Dependency on Investments: Just like with other investment vehicles, your portfolio isn’t guaranteed to perform well. Your long-term growth and success are going to be dependent on the quality of your investments and how you change your investment strategy over time.

Summit Wealth has more than 40 years of experience in the wealth management industry. In addition to managing tax-free retirement accounts, we can help you with almost anything related to financial planning, investing, insurance planning, estate planning, and tax planning.
If you’re ready to take control of your finances and maximize your potential gains, contact us for a free initial consultation today!