Terry Bork CLU ChFC, President   |   Aurum Insurance Services   |   D: 440-605-7230   |   C: 440-666-6032   |   tbork@auruminsurance.com   |   www.auruminsurance.com

Tax Risk

To address tax risk effectively requires managing the current impact of taxes, while also looking into the future and trying to determine the future direction of tax policy and its potential impact.  While not an exact science, current facts and trends can give a clue to the future.

With today’s tax rates at historical lows, and an ever increasing government deficit, one could argue future tax rates will likely be higher. Couple this with the fact that the major deductions you currently enjoy could be reduced or eliminated in the future.

Future Tax Rates

The federal government has huge underfunded liabilities in Social Security and Medicare programs that grow larger by the minute.  In addition, tax rates are at historically low levels.  Historically low tax rates, combined with increasing government debt, could cause future tax rates to increase.

Individual Impact

Many individuals have concluded they will be in a lower tax bracket when they retire, thus minimizing the effect of taxes.  However, the major tax deductions you enjoy during your working years, including mortgage interest, child care, retirement plan contributions, and charitable contributions, are likely to be reduced or vanish entirely in retirement, possibly pushing you into a higher bracket.

This is combined with the fact that traditional thinking, largely based on a current tax deduction, has lead people to believe that maximizing contributions to their 401k Plan and deferring income into the future, is the best strategy to accumulate for retirement.  If a majority of your spending requirements in retirement are met through qualified plan withdrawals, they will be taxed as ordinary income.

Large amounts of taxable income, with fewer deductions, potentially taxed at a higher rate could provide some unexpected and unpleasant results.

Income Tax Diversification

With the future unknown, managing tax risk is best accomplished by Income tax diversification.  Where assets are held controls taxation, and is equally as important as what assets are held.  Based on taxation, where assets are held can be broken into 3 categories; taxed currently (taxable), taxed later (tax deferred), and taxed never (tax free).  Several factors contribute to how much is held in each category.


It is the role of the fund manager and investment advisor to reduce taxes in investment portfolios to the extent possible.  Passive investment is more tax efficient than active management.

Tax Deferred

The real advantage of tax deferral exists when tax rates in the future are lower than current tax rates.  If they are not, or if the tax rate is higher in the future vs. today, and/or deductions are lower, this benefit is minimized or negated.

Tax Free

The Tax Free category is new and unfamiliar to most individuals, and often requires a change in thinking. For those capable of that transformation in thinking, the numerous benefits it provides, including a hedge against higher future tax rates, can play a major role in helping to “Make Life Better”.

There are various assets that call themselves Tax Free.  To be truly Tax Free, however, it must be free of all taxes including federal income tax, state income tax, and capital gains tax.  In addition, income generated must not negatively impact the taxation of Social Security and the Medicare surtax.  Assets that meet those criteria are the Roth IRA and Accumulation Designed Life Insurance (ADLI).

While the Roth IRA meets the criteria of being truly tax free, it has one major drawback…..income and contribution limitations.  ADLI has all the benefits of a Roth and more, without the limitations.  Sometimes referred to as “The Super Roth Strategy”, it is the funding asset of choice in the Tax Free category.

Summary and Conclusion

There are good reasons to place assets in each category, and proper diversification is important.  The first step is to gain a thorough understanding of the Pros and Cons of placing assets in each category, Taxable, Tax Deferred and Tax Free.   Applying that knowledge to your beliefs and values will help determine how much to allocate to each category.

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