ROTH vs IUL as a tax-free source of income? What are sources of tax-free retirement income? Finding tax-free sources of retirement income.
Estate Attorney and Advisor Chris Berry share his insights on “Would a person be better with ROTH or IUL after that 10-year period?
Learn more about the two in this episode of Daily Wisdom.
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Episode Transcript
Background
I guess a little bit of kind of background has to go into these. The idea is that what we’re trying to do is find tax-free sources of retirement income. And most people think taxes have to go up in the future. And so, given that, the concern is if taxes are going up in the future, maybe if I have all these pre-tax accounts, that’s not the best way to manage or handle the assets. Instead, we want to move to more tax-free options.
We’re limited in what our tax-free income sources can be. And it makes sense to understand the three tax buckets. So you can have taxable accounts, like checking, savings, investments, post-tax investments. Second, you can have tax-deferred accounts, like IRAs, 401Ks, 403Bs, traditional IRAs. And then third, you can have tax-free buckets. So this is investments that grow tax-free, like a Roth IRA, a Roth 401K. And this is where index universal life is an option where it can grow tax-free.
Index Universal Life vs ROTH
And so if you have money moved into Roth, it typically goes up and down with the market, but it does grow tax-free. Money that you put into a cash value index universal life, it grows tax-free, but it’s tied to the index, where if the market goes down, you don’t lose anything. If the market goes up, you participate in the up side of the market.
So I’m a fan of index universal life as a tool. I’m also a fan of Roth IRAs, Roth 401Ks. I think all of these tools have merit, it’s just using the tools appropriately. So the question that was submitted was, “Does it make sense to look at an IUL as well as a Roth?” With the understanding that typically, when you put money into a index universal life, it takes some time for the cash value to grow in that tax-free environment.
So typically, we say that this is money that you should be touching over the next 10 years. Which makes sense, if you think about it in terms of time horizon, because the idea is that this would be the last money you touch because it is already in that tax-free environment. So you would probably want to spend down the IRAs or the 401Ks before you spend down the tax-free vehicles, which would be the Roths or IULs.
ROTH or IUL After a 10-Year Period?
And so this person was asking, “Would a person be better with a Roth or an IUL after that 10 year period?” And the answer, unfortunately is, it depends. It depends, really, on what your goals are, what you’re trying to accomplish. What are you investing the Roth in, versus the IUL?
So, for example, my IUL, I’ve had it for a number of years right now, and this past year, it was up 7.8%, which is pretty good, considering that there is no downside where if the market goes down, I don’t lose anything. It has the power of index. So I have an IUL that I’m contributing to, along with a 529 because I know in 10 years, I’m going to have to pay for my kids’ college education. So I’m putting some money into the IUL, some money into the 529.
Similarly, I have a lot of clients in a similar position where they’re putting some money into a Roth and some money into the IUL. Similar in my situation, if I put all my money into a 529 and then I know in 10 years I’m going to start pulling the money out for college and the market goes down right as I start pulling money out, then we suffer from what’s called sequence return risk. So that’s why I’m diversifying where I’m saving by putting some money in a Roth or some into the 529 and some into the IUL. Similarly, I’m saving the same way for retirement. I’m putting some money into Roth and some money into IUL, where that IUL, as I get older, I’m less interested in that death benefit, but it can double as a longterm care benefit, as well. So we’re kind of killing two birds with one stone.
Running a Report
So long story short, I can’t really answer would a person be better with a Roth or IUL after 10 years. What we can do is we can run the numbers and what I find is a lot of times when we do run the numbers, if you’re looking at it from what’s called an internal rate of return, the IUL will outperform the Roth because there’s also a death benefit tied to it. Where if we were to say, “Okay, I’m going to put money to a Roth and put money to an IUL and we’re going to live to age 90,” when you factor in that there is a death benefit kicker on top of it, a lot of times, the IUL might outperform the Roth.
That said, I can run a report where, if you’re interested in how much should I be saving inside of a Roth versus an IUL or if I should be pulling money out of the IRAs to pay the tax, which, for a lot of people, it makes sense right now because taxes are going up in the future, there’s kind of two questions. One is, first, how much do you pull out of the IRAs? And then second, where do you put it? And do you put it in a Roth? Do you put it in IUL? Or do you put it in a combination of both. It really, at the end of the day, that’s going to be an individual question that we would have to answer depending on what your goals are.