This column will explain how FURI can be integrated with state-of-the-art investment tax planning techniques for retired people, including four specific ways to help your clients implement it. If your services include life insurance, retirement plans or ETFs, understanding these ways could expand your income and referrals immediately.

Deciphering the Tax Complexities of Retired People

In a previous column, I described the impact of the new "income-relating" provisions that took effect on 1/1/07 and increased Medicare Part B premiums of high-income retired people. You can review that analysis here:

• Help Your High-income Senior Clients Plan for New Tax Complexities

The analysis indicated that one way to view the increased Part B premiums is as a series of new "phantom" federal tax brackets faced only by high-income retired people. In each phantom bracket, the effective tax rate is 100% plus the taxpayer's regular federal tax liability. Senior taxpayers who earn Modified Adjusted Gross Incomes (MAGI) of $200,000 or more as single filers or $400,000 as joint filers are subject to four such brackets, all of which are narrow in size but punitive in confiscating at least 100% of marginal income.

Initially, CPAs are having a difficult time planning for these brackets because they don't appear on the client's 1040, and the tax impact is delayed by two tax years. For example, for a single filer who reports MAGI of more than $80,000 in 2007, income-relating will increase Medicare Part B premiums in 2009 but not appear on the 1040 for any tax year. (Medicare premiums usually are deducted from Social Security benefits.) The MAGI limits are twice as high for joint filers.

Social Security recipients also can be subject to phantom tax brackets (under current law) as portions of their benefits become subject to tax. For example, suppose that you are a retired person paying tax in the 28% federal tax bracket and you then generate investment income that causes the taxable portion of Social Security benefits to increase from 50% to 85%. The effective federal marginal rate on this income is 51.8%. That's calculated as 28% + (85%*28%). In other words: The last dollar of taxable income is taxable at 28% and also cause 85 cents worth of Social Security benefits to become taxable at 28%.

New Tax Complexities on the Horizon

The complexity described above is under current law – and many retirees and pre-retirees fear that matters will only get worse, because:

• All of the leading Democratic candidates for President advocate rolling back the "Bush tax cuts" of 2001 and 2003 by letting them expire after 2010. This would restore the top federal tax bracket to the 39.6% that existed prior to 7/1/01. John Edwards has proposed even higher rates on taxpayers earnings more than $200,000 to pay for universal health care.
• The "income-relating" of Medicare Part B premiums has not solved the fundamental problem of long-term insolvency in the Medicare program. In the future, it is likely that: 1) Medicare premiums of all retired people will increase under provisions of current law; and 2) the income thresholds for income-related premiums will be reduced, so that more retired people are affected.
• "Income-relating" did more than increase Medicare premiums of high-income people. It also provided the legal permission and operational infrastructure for the IRS and the Social Security Administration to share MAGI data. Because Social Security also faces a long-term funding problem, it is possible that income-relating could be extended to Social Security benefits in the future – i.e., retired people would lose X% of scheduled retirement benefits for every dollar of MAGI over a threshold.
• Likewise, it is possible that Social Security reform could make 100% of benefits taxable for the highest-income retired people, compared to a maximum 85% portion under current law.
• Legislation for both Medicare "income-relating" and the taxable portion of Social Security has been written to discourage retirees from using tax-exempt municipal bond income as a shelter. Under "income-relating" rules, it is possible that a retired couple could earn $1,000 of municipal interest and 100% of it could effectively become taxable (two years later).

To summarize: The tax costs and complexities that high-income retired people face in the future are certainly complex and perhaps bleak. Fortunately, the combination of long-range planning and FURI can create viable solutions.

h3>Flexible Untaxable Retirement Income (FURI)

Successful CPAs will serve the high-income retirement market of the future by using sophisticated "what-if" computer models. Clients will find it advantageous to have the flexibility to take some retirement income (in a given year) from sources that don't generate income tax or income-relating impact.

• Conversely, the most difficult types of retirement income to plan around are those that are inflexible and taxable. They include:

  • Pension and immediate annuity payouts;
  • Variable annuity withdrawals taken under Guaranteed Minimum Withdrawal Benefit (GMWB) programs;
  • Required minimum distributions from retirement plans and IRAs;
  • Bond interest;
  • And mutual fund distributions.

High-income retired people who receive most of their income from these sources may find themselves boxed-in, with little flexibility to avoid potentially punitive marginal income tax rates.

FURI is defined as income that a retired person can decide to take (or not take) as late as December of each year, after the year's tax picture becomes clear. This income can fill spending needs without increased tax impact. Four examples of FURI are:

• Tax-free loans from permanent life insurance contracts;
• Tax-free loans from one-person 401(k) plans;
• Roth IRA distributions;
• And a FURI program built around ETFs.

Tax-Free Loans from Permanent Life Insurance Contracts

Imagine a 55-year old wealthy client who has accumulated $1 million in qualified retirement plans or IRAs. Whether or not this client has yet retired, current income is not needed; so the client plans to let the money keep accumulating on a tax-deferred basis. But is this a smart idea?

The client won't be subject to Medicare Part B "income-relating" impact until age 63. (MAGI earned at age 63 will determine Part B premiums in the first year of Medicare eligibility, at age 65.) The client doesn't plan to become subject to tax on Social Security benefits until full benefits are earned, at age 66. The top federal tax bracket currently is 35%, compared to the 39.6% proposals of Hillary and Obama or the 40%+ proposal of John Edwards. In short, this client may have a more favorable tax picture now than later in retirement.

Each year, taxable distributions can be taken from the plan and then the after-tax amounts can be used to fund permanent life insurance premiums in a non-MEC contract. From age 65 on, the client will have the flexibility to extract FURI from the insurance policy via tax-free loans. Toward the end of the client's 65^th year, for example, a CPA might say: "You need an extra $25,000 of income to meet expenses. But if this income is taxable, the marginal impact will be 55%." In that case, having a FURI pocket available could make retirement more tax-efficient and enjoyable.

Tax-Free Loans from One-Person 401(k) Plans

At retirement, many people ritually transfer 401(k) plan balances to Traditional IRAs that seem to offer comparable tax advantages. But there is one key difference, and that is access to tax-free loans ? which are available in 401(k)s but not in IRAs. Loans taken from 401(k)s are comparable to loans from permanent life insurance programs because in both cases they are tax-free and the net cost of borrowing can be low.

For high-income retiring people who continue to earn some self-employment income, a transfer to a one-person 401(k) plan can be an attractive alternative to a Traditional IRA. The contribution limits in 401(k)s are higher than in IRAs, and plan loans can generally be taken up to the lesser of 50% of the account balance or $50,000.

Roth IRA Distributions

For retirees and pre-retirees who are concerned about higher taxes in the future, Roth IRAs keep looking better. Starting in 2010, the income limits on Roth conversions will be eliminated, and everyone will be eligible to convert money from a Traditional IRA or qualified plan to a Roth.

All else being equal, a Roth conversion can help clients achieve a "tax rate arbitrage" if tax rates go higher in the future. The examples below may help to quantify this advantage for high-income clients:

If tax rates stay constant, the Roth conversion produces the same hypothetical 10-year benefit as the Traditional IRA. But if the marginal rate increases from 35% to 42%, the Roth produces $15,112 more benefit ($140,330 – $125,218).

Equally important: The Roth IRA can be tapped as FURI only in years when the retired client may face high marginal tax rates and need more income. There are no minimum distribution requirements during the owner's lifetime, and in any case qualifying distributions are not federally taxable. Roth conversions can help clients avoid being boxed-in by inflexible, taxable minimum distributions after age 70 1/2 .

A FURI Program Built Around ETFs

Mutual funds have an inherent problem for high-income retired investors who may at times face high marginal tax impact – namely, investors have no control over the taxable distributions that funds pay out. This could become a bigger problem if the 20% maximum federal rate on long-term capital gains is allowed to expire as scheduled at the end of 2010. However, there is another more tax-efficient way to invest in diversified funds, while also enabling FURI planning. It is to dollar cost average into several ETFs through a brokerage account that tracks the tax lots of each purchase.

Most ETFs do not make annual taxable distributions due to the way they are structured so there is normally no tax impact until shares are sold. FURI can be achieved by designating sales of those shares with the highest cost basis (relative to market value) and then netting capital losses against gains.

There are a few caveats financial advisors should heed in recommending FURI programs built around ETFs:

1. These programs will work better in volatile up-and-down stock markets than in sustained bull markets.
2. They will work best when several different ETFs are chosen and when some ETFs have volatile prices. This enhances the potential to have some shares with gains and others with losses.
3. The program can work best to generate FURI in the later years of retirement. Over time, selling high basis shares and holding low-basis shares will build up unrealized portfolio gains. But at the owner's death, highly appreciated shares passing to heirs can qualify for stepped-up basis, under current law.

Individual stocks that pay no dividends also can be included in such a program. However, diversified ETFs may work better by helping retired clients avoid forced sales of appreciated shares because of a downturn in a given company's outlook.

How to Talk to Your Clients about FURI

For many clients, FURI may seem to be a counterintuitive concept, for two reasons:

1. Most people believe their income tax rates will go down in retirement, not up.
2. Most people have been taught that relatively conservative income-producing strategies like CDs, bonds, and immediate annuities are appropriate for retirement.

What has changed? The United States Government needs tax revenue to fill deficits and pay for new initiatives. It is a shrewd move for a populist politician like John Edwards to suggest paying the cost of universal health care by taxing households earning $200,000 or more, because such households are few in number and have minimal voting clout. High-income seniors are an especially inviting target for filling future shortfalls in Medicare and Social Security funding, and that trend has already begun with Medicare Part B "income-relating.

You may find that many of your high-income clients feel tax-vulnerable, even if they can't express specific reasons why. So, try to uncover these feelings with pointed open questions, such as:

• "When a political candidate talks about raising income tax rates on high-income people, how does that make you feel?"
• "When you see your Medicare premiums increase by hundreds of dollars per year, just because you have achieved a high income, how does it make you feel?"

Clients' concerns about higher taxes are important, and expressions of anxiety or vulnerability will reveal opportunities to plan for FURI. The four examples of FURI included in this article should help you see that long-range planning is the key. None of these ideas will work well for clients who reach age 65 or 70 1/2 and then find themselves in a tax predicament. Ideally, these concepts can be monitored annually through teamwork between an insurance/investment specialist and a CPA equipped with "what-if" tax impact models. Now is a good time to form alliances with CPAs in your market who serve high-income retired clients.

A person who retires today at age 60-65 should plan for at least the next 25 years. For most high-income people, that's a long time to be vulnerable to income tax uncertainties.

Show your clients how FURI can reduce retirement income tax worry.