Ed Slott and his IRA education organization have long emphasized two tools in tax planning conversations: Roth IRAs and life insurance. They are not interchangeable, and “tax-free” comes with rules, but the comparison is worth understanding.
Road one: Roth IRA
Roth IRA contributions are made with after-tax dollars. Qualified Roth IRA distributions may be federal-income-tax free, and the original owner generally has no lifetime RMD requirement. Contribution limits, income rules and distribution rules apply.
A Roth conversion is another route: taxable traditional retirement money is converted to Roth, generally creating current taxable income in exchange for the possibility of qualified tax-free distributions later.
Road two: life insurance
Permanent life insurance can build cash value. Policy owners may be able to access that value through withdrawals and policy loans. Life insurance death benefits are generally received by beneficiaries free of federal income tax.
But this is where the tiny print matters. Cash-value access is not automatically tax-free in every circumstance. Policy design, basis, loans, surrender, lapse, modified endowment contract status and other factors can change the tax result. Loans also reduce policy values and death benefits and can cause problems if a policy later lapses.
Different tools, different jobs
A Roth IRA is a retirement account. Life insurance is an insurance contract. One should not be sold as a disguised version of the other.
The useful question is whether your retirement plan has enough tax diversification. If nearly every retirement dollar is sitting in accounts that will generate taxable income when withdrawn, you have concentrated your future in one tax bucket.
There are other forms of tax-exempt or tax-favored income in the tax code, so “only two” should be understood as a planning framework, not a literal inventory of every tax-free item in America. But Roth accounts and life insurance are two major tools worth understanding.
Sources: IRS: IRAs; IRS: Life Insurance Proceeds; Ed Slott & Company: Roth IRAs and Life Insurance.