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Dancing with Your Money: The 2-Step for Tax Free Income and Legacy

Steve Soffer

Ok, cute title… but what the heck is a “2-Step” when it comes to taxes and my money? Well, if you currently have savings in a qualified 401k, 403b or 457 Deferred Compensation Plan, then one of your concerns is probably how taxes will impact your retirement as well as the legacy you leave your family. You might want to consider implementing this simple 2-step financial planning strategy.

First of all, you might wonder, “Is it possible to use existing financial tools to create a dependable, tax-free income for myself as well as a tax-free legacy for my beneficiaries?” It’s a mouthful, but the strategy is actually quite easy to implement… once you understand the strategy behind it.

When creating a retirement plan, I like to think of it as building a financial home. First, you need a solid foundation. No. 1 in my book is safety of principal. You want to make sure that no matter what the market does, even if it crashes again, your principal will be safe. Second, you want to have a growth plan that not only eliminates market risk, but also generates enough income to outpace inflation, so you can live a comfortable retirement lifestyle and ensure that you don’t run out of money during retirement. Now you have a solid foundation established with safety and growth, and of course, if the income is tax-free, that would be a bonus.

The next consideration would be for long-term care. Without protection in this area, your nest egg could be devoured within a short period of time, putting you in a very difficult financial position.

Lastly, you should consider legacy planning. If you don’t, your heirs could be writing a big check to the IRS, and since you’ve worked hard for your money, you prefer to keep it in the family. It’s important in your financial plan to consider the best way to pass any remaining money on to your beneficiaries.

How can you accomplish all of these goals of safety, growth, long-term care, and tax-free income for yourselves and a plan to pass on any remaining money to your heirs income tax free? There are two insurance products that will provide all of these benefits when they are paired together and properly structured. We call this the “2-step,” and it’s basically an annuity that funds a cash-value life insurance policy.

We utilize an annuity because of the built-in guarantee that your principal is safe from market losses while providing growth with uncapped market gains. We pair that together with Cash-Value Life Insurance because of the preferential income tax-free benefits that are allowed life insurance products, as well as optional long-term care features.

Step 1

To begin, I project the expected value of my qualified plan (401k, 403b, 457 Def Comp) to the time I expect to retire. If I am already retired, or when I do retire, I roll over the entire amount to a qualified IRA annuity, and because it’s a qualified annuity, there are no tax consequences. In most cases, you will need to be retired or at least have separation of service from your employer to roll over those funds, but your plan might also allow an in-service transfer. An in-service transfer is when you still work at your company, but your plan allows you to transfer part or all of your account value over to a personal IRA without a penalty, even if your under 59½.

Step 2

Once the funds are in your IRA annuity, we wait one year to avoid any surrender charges, then begin periodic withdrawals. We transfer whatever we do not need for income to the life insurance policy in order to establish an income tax-free vehicle for ourselves and heirs down the road. The face value amount of the life insurance policy is determined by the amount of transfer contributions you intend to make into the policy as well as your age and health.

  • If you’re over 59½, you can withdraw up to 10% of the annuity’s remaining value each year without penalty.
  • If you’re under 59½, to withdraw without penalty, you want to use 72t of the Internal Revenue Tax Code. This allows you to draw out substantially equal payments from your IRA annuity without an early withdrawal penalty. A 72t calculator is best used to calculate the withdrawal amount; ask your advisor to calculate it for you.
  • If you’re age 70½, you can withdraw up to 10% of the annuity’s remaining value each year or the Required Minimum Distributions (RMD) required by IRS. This is accomplished by using a RMD calculator. Many annuities allow greater than a 10% withdrawal (without penalty) if the funds are withdrawn for RMDs.

Now that we know the withdrawal amount, we calculate a corresponding death benefit to construct the life insurance policy. Since life insurance is less expensive the younger you are, we recommend you start contributions at an affordable reduced premium amount while waiting to gain access to your qualified plan assets.

Selecting the proper annuity and setting up the insurance properly is critical to the success of this plan. A Fixed Indexed Annuity (FIA) is what we recommend. These products are linked to the market, but since your money is not actually in the market, it is not exposed to market risk. In other words, if the market goes down, you don’t lose any of your principle. Many are also uncapped with 100% participation rates, thus when the market goes up you get all of the gains. To receive uncapped gains without any losses you must agree to longer crediting periods, which means these uncapped gains may not get credited to the account for 2 to 5 years. Also, some products have fees, while others have no fees but instead a spread. A spread is a percentage amount payable to the insurer only if a profit is earned. Most annuity products allow a 10% withdrawal of your account value each year without penalty.

We also recommend a properly structured Indexed Universal Life (IUL) insurance policy. Once again, your cash value is never subject to market losses. If necessary for income, we can access the assets in the policy to generate tax-free income by the use of policy loans. Many policies have rider options available for long-term care benefits. When the policyholder passes away, the entire death benefit—which includes insurance, all transferred annuity funds and compounded market interest credits (less fees, spreads, withdrawals or any policy loans and interest)— pass to beneficiaries completely income tax free.

Putting It All Together

As funds are transferred out of the annuity and into the life insurance policy, taxes are paid at ordinary income tax rates. The idea is similar to a Roth conversion, moving taxable dollars to a tax advantaged growth strategy. Once the funds are in the insurance policy they are growing and compounding without market risk and are available income tax free. Ask your advisor to prepare illustrations to show how the transfer of funds would work and the tax advantaged benefits you could receive. Once the strategy is setup and properly structured, one withdrawal and one contribution is made each policy year. It’s best to meet with your advisor to review the plan each year. While this should be an easy strategy for any advisor to structure, we set these strategies up on a regular basis, and we’re available should you need any assistance setting up your “2-step” plan.

About the Author:

Steve Soffer helps retirees and pre-retirees throughout the Los Angeles area. Platinum Life works with both the public and private sectors and assists clients throughout the USA.

To contact Steve for more information, you can reach him at or his office at 818-206-2142.


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