A Little Goes a Long Way

Sometimes, when Washington changes tax laws, it’s Big Freakin’ News. Back in 1986, a bipartisan group of senators and representatives rewrote the entire Internal Revenue Code from stem to stern. Publishers killed entire forests printing their analyses in newspapers and magazines, and tax pros spent years catching up with the changes. (Passive loss limits! AMT up!) Five years ago, a Republican majority passed the Tax Cuts and Jobs Act of 2017. The Lorax breathed a sigh of relief because we all got the news online this time, and tax pros are still digesting the new opportunities. (Qualified Business Income! AMT down!)

Other times, changes fly under the radar. This is especially true when Congress sneaks tax goodies into bigger “must-pass” bills, such as year-end appropriations to avoid a government shutdown. It’s like a magician popping a balloon with his right hand, so you don’t notice him slipping the rabbit into his hat with his left.

This week’s story involves tax breaks for retirement savings. 401(k)s and similar qualified retirement plans let you deduct your contributions, which lets you invest more. If your employer matches part of your contribution, that’s even better. But there are specific limits on how much you can contribute, no matter how much you’ll need down the road. You don’t actually eliminate the tax on those contributions — you just defer it until you take the money out, when your rate may be higher than it is today. And if you own your own business, you don’t get that sweet employer match, you pay it! So, while those sorts of plans work well for millions, they fall short for millions more.

Cash-value life insurance can help when qualified plans don’t get the job done. Premiums aren’t deductible; however, you may be able to withdraw your cash value tax-free for retirement. This makes life insurance look a lot like a Roth IRA. And insurance-based plans have always been valuable for business owners with too many employees to maximize their own contributions or for high-income professionals who want to save beyond their 401(k) limits.

However, in 1984, Congress created the modified endowment contract rules, which — without getting into some seriously sleep-inducing technical gyrations— eliminate the tax benefits if you stuff more into the policy than what it takes to fully fund it within the first seven policy years. And those limits were based on a 4% interest rate that was appropriate 38 years ago. Today, prevailing interest rates are far lower than they were back then, squeezing investors even tighter.

Enter Washington – and the actuaries – to the rescue. (An actuary is just someone who kept taking math classes way past the point where you thought there were any more math classes to take.) In 2020, Congress slipped a quiet provision into the year-end consolidated appropriations bill. The new rule drops the interest rates used for calculating MEC limits by 2% and lets them float with real-world conditions. That, in turn, effectively doubles what you can contribute towards growing your cash values. And it means far more people will be able to use life insurance to create meaningful tax-free retirement income—all without a single headline outside obscure insurance industry publications that hardly anyone reads.

I have a lot of fun with these weekly columns, explaining the surprising way that taxes affect the world around us. But this is news you might actually be able to use. If you’re currently sponsoring a retirement plan for your employees, or you’re maxing out your 401(k), and you’re looking to save more, this may be a real opportunity. Call us to take a fresh look at your plan!