In 2008, once we realized an economic crisis was rapidly spreading around the world, the first thought in many minds was the Great Depression.

For most of us, the memory of the Great Depression is secondhand, seen through the eyes of grandparents and parents. But the mental pictures they gave us of unemployment lines, soup kitchens, and apple sellers are vivid and powerful.

We also inherited their vision of retirement, which developed in large part in reaction to the fears they experienced living through the Great Depression. The plan that worked for them included Social Security checks, employer pension distributions, and personal savings—along with the tradition of family support. This system worked well because, typically, by the time they retired their mortgages were paid up, their kids were grown and settled, their tax brackets were lower, and they could very sensibly temper their lifestyles.

But this is where we need to pause. The mindset of previous generations towards retirement is not

the way the current retiring generation really thinks. Today’s retirees will live longer and more likely see retirement in terms of freedom and growth, not caution and restraint. Unlike their parents, many may have second careers, second homes, blended families, dynamic interests, and passionate causes. For these individuals, today’s retirement creates higher income needs and a concern for likely higher taxes. This is a considerably different vision.

Today, the traditional three-legged stool of employer pensions, Social Security, and personal savings needs rethinking. We must look beyond simply increasing retirement assets. And the one issue that is too often overlooked by clients and even advisors is tax diversification.

Tax diversification starts by understanding three basic tax structures based on 1) how the money is taxed going in, 2) how the assets are taxed as they grow, and 3) how they are taxed coming out. Managing these variables effectively can help minimize the tax erosion and also help optimize the value of retirement

Today the traditional three-legged stool of employer pensions, Social Security, and personal savings needs serious rethinking.

In your Retirement Planning,

it may be time to take another

long look at Tax Diversification

benefits over the longer life expectancy today’s retirees are likely to enjoy. Of course we should work towards efficiently managing tax erosion during retirement, but we should start today, by selecting and managing investments not only for high net returns at suitable risk but equally for efficient tax treatment going in, growing over time, and coming out.

Let’s consider the optimal mix of “tax buckets” in preparing for and executing retirement income streams by examining the five available tax buckets that come out of the three tax structures.

Fully taxable defined benefit assets: The best two examples of this group are pension plans and Social Security. Generally speaking, these pay an ongoing fully taxable income stream during retirement, but offer no access to

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principal. The income stream may be fixed or slightly increasing, and it typically will last for the lifetime of the owner.

Fully taxable defined contribution assets: Accounts such as IRAs, 401(k) plans, profit sharing plans and 403(b) plans fit this category. These plans are primarily funded with tax deductible dollars and may contain employer matching funds. Unlike defined benefit plans, there can be full access to principal at any time, but the owner is generally responsible

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Roth IRA

Well Designed Life Insurance

Investment Accounts

Annui�es

NQ Corp Plans

IRA’s / 401(k)

Soc Sec/Pensions

Net Income

_______

_______

_______

_______

_______

_______

_______

(______)

_______

Net Income

_______

_______

_______

_______

_______

_______

_______

(______)

_______

Your Tax Return

Ordinary Income+Capital Gains

+Interest+Dividends

+Other Income+-Adjustments

=Taxable IncomeX Tax Rate

=Taxes Due

You Keep This:

[Usually Tax Free]

[Usually Tax Free]

Some of Your Income Avoids Your Tax Return

Life insurance has not been a traditional retirement “bucket,” but for tax

diversification purposes we believe it has become a very important one.

Not ALL income finds its way to “Taxable” on your Tax formsHere’s an illustration of which funds pass through your tax return

on the way to delivering spendable income

to make sure the funds last as long as needed. This risk of outliving your retirement funds is known as longevity risk.

Fully taxable corporate nonqualified plans: Often referred to as top hat plans, salary continuation, or deferred compensation, these plans involve assets that have been retained on a company’s balance sheet but which are promised to a selected employee in a lump sum or as an income stream at retirement. Amounts received are generally fully taxable when paid, there may be little access to principal, and there is an ongoing risk of a company’s financial ability to complete its retirement promises.

Tax advantaged personal accounts: While personal brokerage accounts, mutual funds and annuities aren’t always grouped together, they fit a general category of accounts that are more widely understood. We will focus most of our discussion on other areas.

Accounts free from income tax: Two particular assets share this tax structure, when chosen and managed correctly: Roth IRA’s and life insurance. In our view, one of the

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best places to have your investments is in a Roth account with its tax-free growth and tax-free payouts. (This is only the case if the account is held for 5 years or more and the distributions are qualified distributions after age 59.5.) Unfortunately, Roth accounts are very limited in their ability to receive new money and therefore represent a very small bucket for tax diversification. However, life insurance policies, properly funded and managed, can be structured like a Roth. Life insurance can grow in value without current income taxation, and funds can be withdrawn in the future without tax if policies are managed correctly. Life insurance has not been a traditional retirement “bucket,” but for tax diversification purposes we believe it has become a very important one.

For this discussion we will be assuming the use of specially designed investment-oriented life insurance policies with minimal death benefits and maximum ability to develop high cash values. These policies will be referred to as “Fixed Specialty Life Insurance”, and closely resemble policies used by corporations to fund employee benefits. A key factor is whether the tax benefits of the insurance policy exceed the insurance

Pull Your Income Taxes from the Right Accounts

IRA401(k)

NQ PlanAnnui�es

IRA401(k)

NQ PlanAnnui�es

LowTaxand NoTax

Accounts

Spending Spending

Taxes Taxes$180,000 $180,000

$97,448 $44,325

It can be less costly to take the taxes you owe on your taxable income from another source.

The funds you take from your taxable accounts to pay taxes on your income are taxable themselves, creating a compounding effect on your tax liability.

charges.

Grouping retirement assets into tax buckets opens the door to some very creative opportunities both for planning and execution, especially with the current 2010 Roth IRA conversion window. In order to determine whether it makes sense to pay taxes today so that clients can reduce taxes tomorrow, the interplay of tax brackets and future spending levels opens the door for a planned income strategy designed to minimize tax erosion of retirement assets.

For example, if clients want to live on a particular income during retirement years, they will want a mix of tax buckets to deliver that income with optimal tax efficiency. If the only available buckets are fully taxable, they will need to withdraw from these buckets an amount for spending and an additional amount for paying taxes … and the taxes on the

funds taken to pay taxes. This forces clients to “gross up” income for taxes, causing higher than expected withdrawals from their retirement funds.

At the other extreme, clients may have moved all of their qualified assets into a Roth and invested their personal brokerage accounts in municipal bonds to achieve low taxation. This strategy may result in low taxes, but avoiding taxation in the 20% combined state and Federal tax bracket, for example, may be overkill. People paying taxes at the 20% rate might regret having converted to a Roth at a 40% rate in a previous year.

Here are two simple conclusions: First, retirement income needs cannot be cast in stone years in advance. Second, tax brackets will change. These two concepts make maximum flexibility important, so that each retirement year’s income mix integrates as

Example of Managing Taxes with Source Selec�on

Tax Free Sources

Tax Advantaged Sources

TaxableSources

Over But not Over Rate

-

Over But not Over Rate

Income Taken: 277,448 Taxes: 97,448

Net Spendable: 180,000

Income Taken: 224,325 Taxes: 44,325

Net Spendable: 180,000

2010 Fed Rates Plus 5% Assumed State Taxes 2010 Fed Rates Plus 5% Assumed State Taxes

Effec�ve Tax Rate: 35% Effec�ve Tax Rate: 20%

All Taxable Income Sources Diversified Income Sources

373,000 and over 40%

209,250 373,650 38%

137,300 209,250 33%

68,000 137,300 30%

16,750 68,000 20%

16,750 15%

373,000 and over 0%

209,250 373,650 0%

137,300 209,250 0%

68,000 137,300 25%

16,750 68,000 20%

16,750 15%

many different types of accounts as possible. While tax advantaged and tax free accounts are preferable, fully taxable accounts can still be a very important component of the final mix of resources, especially for the lower end of the income stream.

In many cases, when you can deduct contributions to tax deductible accounts while you are in a higher bracket, and then pay income taxes on the resulting income from a lower tax bracket, you can reduce your taxes and help to increase your retirement income. Additionally, the tax advantaged and tax free accounts can help assure that the mix of retirement income will not exceed the lower tax brackets. The tax free accounts will be most important for people with higher retirement income expectations, since the highest portion of their income will be the most likely to trigger maximum taxation. Note also that the alternative minimum tax (“AMT”) presents even more issues, and adds to the importance of tax flexibility. The AMT applies to incomes exceeding an annually declared amount and was intended to raise taxes on people claiming excess deductions. Since its enactment, the AMT tax penalty has been applied to an increasing number of tax returns, including many taxpayers who are not the target of the penalty.

So what’s the perfect combination? Unfortunately,

we only know today’s tax environment. One of the two simple conclusions mentioned earlier is that tax brackets will change over the next 10, 20, or even 50 years, but we don’t know how. What we do know is that a broad mix of funded and available buckets would be very wise. For example, when the 401(k) plans and related structures went into effect in 1980, tax brackets were very high, and the growing popularity of these savings structures was based on maximizing growth of tax qualified assets by minimizing tax erosion. Today, the tax environment is comparatively low, so accounts funded with after tax dollars become comparatively more attractive in minimizing future tax erosion on retirement assets.

There is great news in circumstances like this. After-tax accounts (excluding Roth) are not limited in the amount that can be invested now. If you are behind in your retirement funding due to poor investment performance or insufficient contributions, now may be the time to increase your rate of after tax savings. The new money can be directed toward those tax buckets which can deliver tax free retirement income in the future.

Partners You Would Rather Not HaveSome clients will resist any diversion of new savings

from tax-deductible plans like IRAs and 401(k)s.

What they need to consider is the partnership they are creating with the state and federal government. The tax deduction is offered in exchange for a share of the account being funded. Here’s a hypothetical example: If we assume that someone is able to direct $1,000,000 of income over a period of years to a

deductible account, and he saves 35% in taxes, he must understand he has new partners. Both the state and the federal government also have a stake in his retirement plan. Thus, if the fund grows over time to an amount that can deliver a substantial retirement income, the government will expect its share of taxes out of that income. As the account grows, so does the tax liability in total dollars.

Even more, the government has the ability to declare that its share will be higher at any time, just by raising taxes. If the applicable tax becomes 45%, the taxes due back to the government would increase even more. That’s not a bad return to the government for deferring taxes during the funding years.1

Roth vs. Specialty Life Insurance All of this discussion points to the fact that the least

funded bucket for most people is the after-tax/tax-deferred/tax-free structure. Roth is one application of this structure, but income and contribution restrictions prevent many from taking advantage of Roth. Life insurance can mirror the Roth structure and offers an alternative to overcome those restrictions and provide an important element in the retirement strategy. We should describe what this product is and what it isn’t.

Specialty Life Insurance, as used here, is personally owned life insurance where the cash value is held in an insurance company’s general account, earning a declared interest rate or a lower fixed interest rate paired with an indexed participation in the stock

market.

In all cases, the intention is to accumulate funds without any current taxation on the gains. In addition, since these products are life insurance policies, they offer a tax-free death benefit that is higher than the cash value and are available to complete retirement funding in case the insured dies prematurely. The death benefit helps protect the surviving family as well. This death benefit is part of the “insurance wrapper” which has a cost. When the cost of the insurance wrapper is more than offset by the tax advantages, the life insurance policy becomes a very competitive choice. Of course, one of the ways the insurance charges are minimized is that the lowest allowable death benefit is selected, a strategy consistent with the buyer whose primary goal is accumulation.

Fixed Specialty Life Insurance or AnnuitiesTypically, an income stream is taken out of the fixed

life insurance policy over a number of years. If the policy has been structured properly, the income stream can be taken out tax free, as a return of basis or as a policy loan, or both. We believe this is a huge advantage for life insurance policies over fixed annuities, where withdrawals trigger ordinary income first until the contract value is at or below cost basis. Certainly, a fixed annuity holder could also “annuitize” his income, but that cuts off access to principal and spreads the basis over a period of years. Annuitized income is partially taxable during the early years (application of the exclusion ratio), but then fully taxable at ordinary rates in later years. Fixed

Today, when we are prone to expect increasing taxes to cover very long term

government commitments, tax efficiency becomes paramount.

1Please note: the example given is hypothetical and for illustrative purposes only. It does not represent a specific investment. Past performance does not guarantee future results.

annuities have no ability to pay out tax-free income in the form of policy loans. It is not the purpose of this paper to fully develop the differences between fixed life insurance and fixed annuities in the production of income. There is a place for both products, and we may recommend either or both products in the right circumstances. The key point we are making is that fixed annuities do not deliver fully tax-free income, which places them in a different bucket.

Having spent many years in financial planning helping clients accumulate funds in multiple asset classes excluding life insurance, we have been forced to do some rethinking. All advisors should, because every change in tax law seems to remix the list of available strategies. Today, when we are prone to expect increasing taxes to cover very long term government commitments, tax efficiency becomes paramount. Under these conditions, a life insurance product with tax-free build up of its cash value, a tax-free death benefit, tax free income, creditor protection, and lower cost of insurance now becomes a very attractive choice. We believe life insurance now belongs in retirement planning, and advisors who can’t overcome a bias against life insurance will not be serving their clients as well as their clients deserve.

Ultimately, it’s not whether a client has an investment account, a fixed annuity or a fixed specialty life insurance policy. The best strategy will be to have a reasonable amount of as many tax buckets as possible. Think of it this way: a typical office color printer can

reproduce thousands of colors by correctly blending just four basic colors—cyan, yellow, magenta and black. But when one of those colors is missing, the result is dramatic.

The same truth can be applied to retirement income planning from a tax diversification perspective. When all three tax structures are managed effectively using the

five available buckets, you can get the desired income result and lower taxes year by year. When one structure is under-utilized you run the risk of less net income and higher tax erosion.

In which situation would you prefer to see your future? For many, good tax diversification can be a key factor in determining how well prepared they are for retirement. As advisors, we must go beyond the limited focus on savings rates, investment results, and spending patterns. Poorly positioned assets relative to their tax impact could severely damage an otherwise excellent plan.

If we are serious about serving our clients, we will make certain that their tax options during retirement will be fully developed. Given the amount of time it will take to fill each of the tax buckets, we need to start now.

Cyan

Yellow

Magenta

Black

Color Printers Perform Best When All 4 Ink Cartridges Do Their Share

Thousands of Colors

Cya

Yellow

Magenta

Black

Cri�cal Missing Components

• Some Tax BenefitsInvestmentsAnnui�es

• Generally Tax Free

TaxAdvantaged

• Ordinary IncomeQualified andNQ Plans

Less Incomeand

More Taxes

Re�rement Income Without All 3 Tax Buckets Can Fall Short

Cri�cal Missing Components

Less Income

• Some Tax BenefitsInvestmentsAnnui�es

• Generally Tax FreeTaxAvoidable

• Ordinary IncomeQualified andNQ Plans

Most IncomeWith

Least Taxes

Controlled Taxes

Desired Income

TA

Controlled Taxes

More Taxes

Securities and Investment Advisory Services offered through NFP Securities, Inc. a Broker/Dealer, Member FINRA/SIPC and a Federally Registered Investment Advisor. STRATEGIC STEWARDSHIP, Inc. is a member of PartnersFinancial, a division of NFP Insurance Services, Inc., which is a subsidiary of National Financial Partners Corp,

the parent company of NFP Securities, Inc.

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Phone: 770.615.3800 • Fax: 770-615-3805

©2010 Strategic Stewardship, Inc.

NFP Securities. Inc. and Registered Persons in their capacity as Registered Individuals with NFPSI do not provide legal or tax advice. Clients must consult with their own legal and tax advisors. NFP Securities, Inc. and Strategic Stewardship are not Certified Public Accounting (CPA) firms. Any Federal tax advice contained herein

is not intended or written to be used, and cannot be used by you or any other person, for the purpose of avoiding any penalties that may be imposed by the Internal Revenue Code.

ABOUT THE AUTHOR

Greg Freeman is a graduate of Bucknell University and the Washington College of Law at American University. He began his career at the U.S. Securities and Exchange

Commission and then went into corporate law at Connecticut General Life Insurance Company.

Since 1979, Greg has worked as a financial professional in the Atlanta area. From 1990-1992, Greg was Sr. Vice President, Development at Walk

Thru the Bible Ministries. In 1992, he began Strategic Stewardship as a Biblically based financial planning

process and later created a planning firm by the same name. Greg has been active with the Fellowship of

Companies for Christ, Kingdom Advisors, and Roswell Community Church.

Strategic Stewardship’s clients are primarily high net worth families and business owners, many of whom

have become retirees.