Publication: Investor's Notebook
RETIREMENT REQUIRES DIVERSIFICATION | |
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Investor's Insight - Friday, March 10, 2006
"A Digest of Investment Opinion From the
World's Leading Financial Advisers"
Comment The Post Below...
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RETIREMENT REQUIRES DIVERSIFICATION, NOT TAX-FREE INCOME
by Scott Burns
Q: My wife and I are in our mid- to late 20s. We are on
track to accumulate over $3 million in our retirement
accounts by age 60. My plans are to eventually switch that
money out of our growth and value-oriented mutual funds
and stocks into tax-free municipal bond funds. Then our
investment income will be federal and state tax-free. Any
opinions on this plan? -- N.K., Dallas
A: When I was in my 20s I made similar plans about what I
would do when I was 60. Real life, both market and personal,
intervened. Trust me, it will for you as well. We should
build our portfolios accordingly.
There are two problems with investing 100 percent of your
money in tax-free bonds as you approach retirement. First,
you'll have no protection from inflation. Your portfolio
will start to wither the moment you convert it to bonds.
Second, the rules for the taxation of Social Security ben-
efits require that you must include tax-free bond interest
in the measure of income. As a consequence, your tax-free
income will induce the taxation of your Social Security
benefits.
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Worse, by the time you are in your 60s, it is a lead-pipe
cinch that virtually all of your Social Security benefits
will be subject to taxation. (For more on this subject,
check my Web site, www.scottburns.com, or read "The Coming
Generational Storm," which I co-authored with economist
Laurence J. Kotlikoff.)
The alternative is diversification of both portfolio assets
and types of accounts. Young workers, in particular, should
pursue tax-efficient investing in taxable accounts and in-
vestments in Roth IRA accounts. Withdrawals from Roth IRA
accounts are tax-free.
Q: I told one of my best friends I was considering buying a
universal life policy as a retirement investment. I get a
policy, pay the principal at about 8 percent interest, and
after five years I can withdraw my principal tax-free. After
my principal is depleted, I can withdraw my interest earn-
ings as a loan, again tax-free.
He told me to contact you for your opinion as he had heard
of this type of investment and knew there was some risk in
it. What advantages or disadvantages can you tell me about
this investment? -- L.P., by e-mail
A: There are many good uses of universal life policies.
Yes, it is possible to make large enough payments into
the policies that the earnings on your cash value may
eventually eliminate the need to pay additional premiums.
This should not be confused with thinking of the policies
as a risk-free source of income for the rest of your life.
In the '80s, one of the favorite sales techniques for sell-
ing these policies was called "the disappearing premium."
The sales agent told you that if you paid premiums for
about seven years, you would accumulate enough cash value
that you would never have to pay a premium again.
Those policy projections were based on the high interest
rates prevailing when the policies were sold. When seven
years had gone by, however, interest rates were down sharp-
ly. People learned they might have to put in many more
years of additional premiums. It made a real mess of
people's lives.
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The same could happen to you. The 8 percent return pro-
jection may not materialize, and you'd have to pay in
more premium money.
Worse, since the policy continues to generate charges for
life insurance benefits, the cost of the insurance starts
to reduce the return that can be distributed out of the
policy.
If your life insurance sales agent has walked you through
only the blue sky assumptions in the policy, I suggest you
ask him to walk you through some stormy sky assumptions --
like much lower returns.
The worst possible result is that you can borrow out the
policy earnings tax-free, but interest charges reduce the
accumulated cash value to the point where you are asked
to pay additional money into the policy -- perhaps at an
inconvenient time, like your 79th birthday. If you don't
pay in the additional money, the policy would lapse. Then
all the income borrowed becomes taxable.
You don't want that to happen late in your retirement.
(Investor's Insight reflects the opinions of experts. It does
not recommend any specific investments, and no endorsement is
implied or should be inferred. For more information, contact
the individual firms cited).
COPYRIGHT 2006 UNIVERSAL PRESS SYNDICATE
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