Author: Jay Jiyuan
The best way to know is to read my thoughts on the blog site: Ideabins.blog. I have been a managerial consultant for 10 years and then college teaching for 12 years. Entrepreneur in heart, interested in financial leteracy
First published on LinkedIn, then on my ideabins.blog site. The content is relevant for this site as well!
Uncle Sam is pushing Roth retirement accounts for now, and I see no sign of change in the near future.
I came across this interesting article on Kiplinger.com published on June 11, 2023. The author DAVID FAULKNER did an excellent job in highlighting the recent moves by lawmakers encouraging people to contribute more to #RothAccounts.
Being a practitioner, Faulkner does not blow the loudest trumpet for recent changes installed by Washington, but uses a cautious tone in his discussion on “Rothifying” retirement plans. If anything, he alerts us, “there are benefits and drawbacks to each type of account.”
That said, it is easy to see that the recent upsurge arises for a reason or reasons, especially on the government side. For one thing, #SIMPLE and #SEPIRAs can now accept #RothContributions, while “Prior to the passing of SECURE 2.0, SIMPLE IRAs and SEP IRAs could accept only pre-tax funds.”
This is not a small feat if we keep in mind how many sole proprietors there are in the country: about 27.8 million non-farm sole proprietors in 2022 (https://lnkd.in/gcZGq5gf.)
Another important change: “Workplace plans can allow employer-matching contributions to be made on an after-tax (Roth) basis.” Recall in my own post “Roth or not Roth, this is the (retirement) question” I specifically said employer’s contribution is using pretax money, which means the employee contribution (using after-tax money) must be separated from employer contribution (using pretax money). Allowing both contributions to be on the same page is a convenient plus.
“Effective in 2024, 529 college savings plan beneficiaries will be permitted to roll over up to $35,000 penalty-free from their plan to a Roth IRA over the course of their lifetime.” This makes sense given #529Plan works the same as Roth: Contribution with after-tax money and distribution is tax-free.
Uncle Sam seems to want to collect more tax revenue now rather than later, and no other law change is more revealing than this one: “Starting in 2024, all catch-up contributions for workers with wages over $145,000 during the previous year must be deposited into a Roth account. (This year, as in the past, pre-tax or Roth contributions are allowed.)” By requiring #HighEarners to make after-tax contributions, Uncle Sam can gather more tax in 2024 and beyond.
This is the reason I believe Roth retirement accounts are safe to stay now and for the near future, as Congress wants to gather more tax revenue today than later.
The only weakness of this article is to talk about “retirement savers” in general without separating people with different income levels and income structure (in terms of active, passive, and portfolio), like I did in my post. That said, this article updates us with the latest legal changes, something my post did not do.
This is the full-length version of my LinkedIn post https://lnkd.in/evM2KjbC published on June 27, 2023, quoting an excellent article on Forbes entitled “Retirement Account Taxes: Should You Pay Now Or Later?” by Tolen Teigen on December 14, 2022. I promised to write a longer post on my WordPress site and now it comes.
The Takeaways:
- Two retirement investment strategies are to invest for retirement using pretax money or after-tax fund. The former is called #TaxDeferral while the latter #TaxNow.
- #TaxDeferral says we should always delay paying taxes as much as possible for as long as possible. The financial products or the investment vehicles that fit this approach include traditional IRA and 401(k), both are funded by pretax (i.e., skipping tax or paying $0 tax on the current year) money in contribution.
- #TaxNow goes the other way by saying we should pay contribution taxes today and become worry-free for the future when we take our money out, typically during retirement ages. The financial products or the investment vehicles fitting this approach include Roth IRA and Roth 401(k), both are funded with after tax (i.e., not skipping tax) money in contributions.
- If there were no Roth retirement accounts, the Tax Deferral approach would remain popular forever, because not many income or contributions are deemed “qualified” by IRS.
- One fundamental difference between Roth and non-Roth (i.e., traditional) retirement accounts is the time when taxes are levied. Tax deferral saves on contributions today, while tax now saves on distribution later.
- Contribution, distribution and conversion are the three crucial timepoints all with direct tax consequences. Contributions come before distribution, while conversion happens in between the two.
- Tolen Teigen argues that the only key factor to consider whether to invest in Roth or in traditional retirement accounts is the tax brackets you will be in now and in the future. To the extent that retirement means lowering tax brackets, we should invest in traditional retirement accounts.
- My own model adds two more factors: expected future income after retirement and possible tax law changes on Roth accounts. Both favor investment in the Roth accounts.
- Working- or middle-class people generally rely on active income through employment, and retirement marks a turning point toward lower income; while high net worth individuals are more likely to have active, passive and portfolio incomes and retirement may mean a harvest time with higher income than before. These people will benefit more from Roth accounts (Roth IRA & Roth 401(k)).
- The uncertainty in future tax law further encourages investment into Roth accounts as much as possible and as early as possible.
Tax Deferral vs Tax Now
Teigen asks a meaningful question of whether we should follow the #TaxDefferal or #TaxNow strategy to save on taxes. In truth, the two tax strategies apply to many different incomes and investments but since Teigen limits himself to retirement savings and investments, let’s do that as well.
Deferred taxation (#TaxDeferral) approach basically says if possible, we should always delay paying taxes as much as possible for as long as possible. The financial products or the investment vehicles that fit this approach include traditional IRA and 401(k), both are funded by pretax money in contribution.
#TaxNow goes the other way by saying we should pay our taxes today and become worry-free for the future when we take our money out, typically during retirement ages. The financial products or the investment vehicles fitting this approach include Roth IRA and Roth 401(k), both are funded with after tax money in contributions.
The two approaches do not have the same popularity or the number of followers. #TaxDefferal is without a doubt the dominant strategy. If there were no Roth accounts (Roth IRA and Roth 401k), #TaxDefferal would remain its dominance forever. The reason seems to be obvious: Not many types of income are deemed as “nontaxable” by IRS or more accurately tax “deferrable.” So why not take advantage of that rare opportunity and legitimately skip paying taxes?
The Crucial Timepoints for Tax Savings
One fundamental difference between Roth and non-Roth (i.e., traditional) retirement accounts is the time when taxes are levied. Let me first introduce the #ThreeTimepoints of #Contribution, #Distribution and #Conversion, which all trigger direct tax consequences.
There is a clear sequence among the three: Everyone’s retirement investment starts from contribution, which is when you add money to your retirement account, typically while you still work. But contributions can be made anytime throughout lifetime, even after retirement. All retirees can contribute to traditional IRAs if they earn income, retirees can also contribute earned income (e.g., salaries, wages, tips, or bonuses but not capital gains, dividend or investment interest) to a Roth IRA indefinitely.
Contribution is just one side of the retirement story. At one point of your life you must take the money out to better enjoy your retired life, whether through lumpsum (e.g., in a life insurance policy) or stream of periodical payouts (e.g., in an annuity). This is called distribution or withdrawal. Contribution must happen first, and distribution must follow contribution.
Finally, conversion can happen anytime between contribution and distribution. For example, one can convert a traditional IRA to a Roth IRA and that is a taxable event in the eyes of IRS. This post does not talk much about conversion but only contribution and distribution.
Rules Governing Distribution
Both contribution and distribution are governed by tax rules. For distributions one rule is called the “Required Minimum Distribution (RMD),” which applies to traditional IRAs, SEP IRAs, SIMPLE IRAs, and retirement plan accounts such as 401(k), 403(b), and 457(b) accounts. RMD demands that at certain age (72 now for most retirement accounts) one must take retirement money out, and if one does not withdraw at all, or withdraw less than the RMD amount, you may still be subject to a penalty.
Let’s say you have a traditional IRA with a balance of $500,000 at the end of 2022, and you turn 73 in 2023. Now, according to the IRS life expectancy table, your life expectancy factor is 24.7, which basically says on average you have another 24.7 years to live.
To calculate your RMD, divide your account balance by your life expectancy factor: $500,000 ÷ 24.7 = $20,243.90, this is the minimum amount you must withdraw from your IRA for the current year to meet the IRS requirements.
And if you failed to withdraw that $20,243.90, the IRS has the authority to take 25% out of your account, which comes to roughly $5,061.
But if you take out anything less than $5,061, IRS can still punish you. For example, say your RMD is $50,000 and you only take $30,000, you’d be short $20,000 and could owe a penalty of $5,000 (i.e., 25% of $20,000) to IRS.
(Note the RMD penalty used to be 50%, but it has been reduced to 25% starting in 2023 with the passage of the SECURE Act 2.0, effective in 2023.)
Importantly, funds in the Roth accounts are not subject to RMD during the account owner’s lifetime, adding another attractive feature to Roth, which is not only tax-free for distribution but RMD free.
Crucial Decisions Require Conscious Attention
The common feature shared by contribution, distribution and conversion is consciousness, meaning they don’t just happen but require one’s full attention and conscious decisions.
Consider “investment earnings” for a comparison, which also have tax consequences just like contribution, distribution and conversion but don’t require conscious decisions because they work in the background, more or less automatically, much like interest earnings from depositing money in the bank. Investment earnings also occur continuously, not a discrete event.
How Are Crucial Timepoints Related to Tax Strategies?
Now that we know the #ThreeCrucialTimepoints above, #TaxDefferal is the #SaveOnContribution strategy, while #TaxNow is #SaveOnDistribution strategy.
Contributing without paying taxes (e.g., traditional IRA, 401k) is like parking your car head in first: It’s convenient and you are not required of paying any tax. Later on, however, after you are done with shopping you want to leave the parking lot. At that point you do have to pay taxes on the distribution of your earlier contributed money for retirement. This is like backing out of the parking lot with tails first.
On the other hand, #TaxNow or #SaveonDistribution approach corresponds to “Backing in, driving out” parking method. Since you have taken the trouble of parking your car with tail in first (i.e., paid your tax for the retirement investment), after you finish shopping you can hop into the car and drive off smoothly, knowing you have no tax to worry about.
Teigen vs. “Wooster” Models
Of course, #TaxNow and #TaxDeferral differ not just by convenience but by financial payoff, which is the whole point behind Teigen’s discussion and mines.
Teigen’s core idea is very simple: It considers which #TaxBracket you are (and will be) during different stages of your life. By this factor #TaxDeferral (i.e., #SaveOnContribution) makes a lot of sense as most people will enter a lower #TaxBracket during #Retirement than they are working. #TaxNow or #TaxOnDistribution makes sense only if no change in #TaxBracket or even increase to a higher bracket, such as when someone just begins working vs 20 years later with several promotions in their career.
My model adds two more factors to Teigen: expected future earnings and possible tax code change with Roth accounts (Roth IRA and Roth 401k). I call it the “Wooster” model as my friends back in college called me “Wooster” even though my real last name is “Wu.”
The Wooster model is more complete and will make substantial differences when we take three dimensions into consideration at the same time: #TaxBrackets, #FutureEarnings and #TaxCodesChangeOnRoth.
Overall, my model will tip the balance toward #TaxNow or #SaveOnDistribution, in favor of using — or converting to — the Roth accounts as the main retirement investment vehicle, especially for high income earners.
For the rest of us, putting money in a regular 401(k) or regular IRA is fine. As a general strategy, I agree with Teigen that we can and should use both strategies, meaning investing in both traditional IRA and 401k and the Roth accounts.
Why Future Earnings Matter
Focusing on tax brackets has a logical problem: The tax bracket is determined by income. For the 2023 tax year, we have the following brackets with the corresponding incomes (for single filers):
- 10%: $0 to $11,000
- 12%: $11,001 to $44,725
- 22%: $44,726 to $95,375
- 24%: $95,376 to $182,100
- 32%: $182,101 to $231,250
- 35%: $231,251 to $578,125
- 37%: $578,126 or more
Focusing on tax brackets but ignoring potential changes in future (retirement) income is like reading the odometer without understanding where the driver went and how far away the destination was. It is the trip plans and patterns of traveling that drive up the odometer, not the other way around.
That sounds fair enough but if income determines tax brackets, what determines income? The answer depends on how — and what — incomes are earned by whom.
For many if not most middle class people, income depends heavily on #ActiveIncome throughout their working lives. This means, among other things, retirement marks a significant turning point in their personal and social lives — but also in the amount and structure of income. After retirement they will no longer receive active income from employment. Many of them will fall into a lower tax bracket, for example from 22% (i.e., for an active income between $44,726 and $89,050) to 12% (i.e., with a retirement income between $10,276 and $44,725).
For high net worth individuals the story is different. Their income comes from three sources of active, passive and portfolio incomes (I will discuss these concepts in another post). Unlike their working or middle class counterparts, retirement makes a smaller income difference. In fact, to the extent they have typically invested in long term growth financial products, retirement ages are the “harvest time” potentially with even higher earnings.
Here is a real life example of how investing in long term stocks can build fortune. According to Motley fool.com, if one had invested $10,000 in Apple stock on September 16, 1997, when Steve Jobs returned to Apple, one would have $2.5 million today. Better still, for all the years in between, as long as one does not sell the stock, one owes no capital gain tax because the gain is “unrealized” while the stock is kept growing in value. You don’t have to be a rocket scientist to figure out which saves more on taxes: Paying taxes at the contribution time in 1997 or paying tax at the distribution time today.
Knowing this picture of expected future earnings in retirement helps us understand why high income earners favor Roth accounts, which allow them to pay taxes on a smaller amount of income early on for contributions but walk away tax-free later with higher income for distribution, matching the “backing in, driving out” method in parking.
The Tax Treatment of Roth Accounts
The tax codes have been generous to Roth accounts, essentially making them tax-exempt, unlike other tax deferred accounts like traditional IRA and 401(k). However, there are two issues with Roth accounts we must know.
The first issue concerns contribution: Roth 401(k) and Roth IRA are (largely) funded with after-tax dollars. I say “largely” because Roth 401(k) is not the same as Roth IRA, the former is employer sponsored just like traditional 401(k) is, while the latter self-administrated.
Having an employer sponsored plan makes things more complicated. Like in a traditional 401(k), employers can choose to make voluntary matching contribution using pretax money, while employee’s own contribution always uses after-tax money. The money from the two sources must be separated, and the employer’s pretax money will be placed in a regular, tax-deferred 401(k) account.
Important Note: With the SECURE 2.0 Act, which was passed in December 2022, employers can now make matching contributions to employees’ Roth 401(k)s with after-tax money.
This new contribution rule solves the second issue concerning distribution. Before the new law: Roth IRA and the part of Roth 401(k) money contributed by employee, are tax-free in distribution, while the part of Roth 401(k) contributed by employer with pretax money will be taxed just like in traditional IRA or traditional 401(k).
Now with the new law, employers can contribute Roth 401(k) with after-tax fund, then employees won’t have to pay taxes on the money when they withdraw it later on.
There are two minor conditions to be satisfied by Roth accounts before tax-exempted distribution can happen: The money must wait for at least five years after the Roth IRA owner established and funded their first Roth IRA, and the Roth IRA and Roth 401(k) holder is at least age 59½ when the distribution occurs, otherwise the distribution will be subject to a 10% tax penalty. They will be treated differently at the time of distribution.
For a hypothetical example, say you had your first Roth IRA account in 1995 when you were 55, and your second Roth IRA in 2000, when you would be 60, you would be qualified to take tax-exempted withdrawal in 2000 because you are older than 591/2 and your Roth IRA money has been sitting in the account for 5 years.
These two conditions for distribution are not particularly demanding, therefore we expect most people would have no problem to receive their money tax free, penalty free and RMD free.
What we might have a problem with is in the future.
The Potential Change of Tax Codes
There is a possibility that Congress may change the tax law for Roth accounts some days in the future, especially with the national debt at such a high level. This is another reason why people may want to take advantage of Roth accounts today, because even with future changes the existing accounts are likely to be exempted.
To be sure, there are people arguing that future changes involving Roth accounts, especially Roth IRA, are unlikely to happen. An interesting article by Investopedia lists five reasons for that. For example, since Roth IRA is funded with after-tax money, withdrawals should be tax free in order to avoid double taxation. Furthermore, having tax sheltered retirement plans like Roth IRA encourages investors to buy government debt. There are already tax-deferred retirement plans like traditional IRA and traditional 401(k), so if we change the tax-free withdrawals in Roth accounts, we will “almost certainly kill the program.” The fourth reason is that Roth IRA accounts are generally small with the contribution limit of $6,500 for those under age 50 and $7,500 for those above 50.
The last reason offered by the Investopedia article is that even with future taxes on Roth account withdrawals, the new taxes will apply to new accounts. The current Roth accounts will be exempted. This is not exactly a reason for no tax change, but rather for preparation of changes in the future.
This in my opinion is exactly why we should invest in Roth accounts as much as possible and as early as possible. After all, you never know what may be coming in the future for sure. One may argue that although Roth IRA and Roth 401(k) are funded with after-tax money, the government may still charge taxes on capital gains at the point of withdrawal on any portion of earnings above and beyond the original contributions.
This is just like your investment in the stock market: Say you bought and hold the Apple stock using your after-tax money, you still must pay capital gain tax — not every year but at the year when you sell the stock. Worse, if you hold the stock for less than a year, your capital gain tax rate is just regular income tax rates of 10% to 37%.
True, such a hypothetical new tax on distribution or withdrawal will kill Roth accounts as we know them today, and turn them into one of the investment accounts. For now it seems highly unlikely. But remember, the only thing not changing is change itself.
The Takeaways:
- The deaths of five passengers in the tourist submersible searching for the Titanic teach us a lesson about how important it is to have liability insurance. Asking people to sign liability waiver may or may not work in terms of absolving the OceanGate Expedition in case it is proven this is a wrongful-death case.
- The makers of the submersible might also be liable if they caused any malfunction.
- Signing liability waiver is not a silver bullet, and liability waivers must be clearly worded and unambiguous in their intent to relieve any and all legal liability, even liability for negligence, which is unusual and unlikely to be a part of the insurance contract. If the waiver is buried inside other provisions and hard to find, it may not be enforceable. Finally, Waivers contrary to public policies are also not enforceable.
- We don’t know who the insurer is for the OceanGate but we can assume the company pays a high premium due to the nature of submersible business.
I don’t know about you, but I can’t stop thinking about the five passengers in the tourist submersible who have been declared dead by the Coast Guard today, as reported by USA Today. I know they did not want to die, as they had made an effort to make regular underwater noises on Tuesday and Wednesday, presumably trying to let the outside world know their dire situation. I can fully imagine how desperate they were in the last minutes of their lives, knowing they could not do anything to save themselves, even with all the financial resources they now left behind on the land.
The story is not over yet, as the vessel would have to be lifted out of the water and by then we will know more about what happened. But what can the insurance business learn from this catastrophic event?
What the AI Engine Has to Say
I asked the question to Perplexity.AI (Copilot 5) and here are what the AI engine has to say:
“From an insurance perspective, the missing tourist submarine searching for the Titanic teaches us that being adequately insured is the best way to prepare for unexpected losses. It is important for high-risk businesses to have liability insurance to cover any potential losses or damages. Liability waivers may not always absolve the company in a wrongful-death case, so it is important to have insurance coverage.”
” Most operators buy liability insurance anyway because the waiver forms they ask clients to sign may not ultimately be enforceable. It is important for high-risk businesses to have liability insurance to cover any potential losses or damage.”
” There is also a question of liability that goes back to not just OceanGate but the operator of the parent vessel, Polar Prince, as that vessel is Canadian flagged and based.”
In other words, liability insurance is needed for all three entities involved: The operator OceanGate, the manufacturer of the submersible, and the operator of the parent vessel.
The Insurability of Entities and Individuals
Just because entities need liability insurance does not necessarily mean they can get it. Even if they can find insurers to write policies for them, they (OceanGate and the manufacturer of submersible) may have paid high premiums because they are in a highly risky business and many insurers may not be willing to cover them.
The same is true for individual passengers on their personal lines of insurance: Many insurers may not be willing to cover them after finding out their plan to travel down to the ocean. This is insurers’ way of selecting good risks and avoiding bad ones. Even if they agree to offer a policy, they may specify riders or endorsements to ask for higher premiums to compensate for the extra risk they must take.
The Public Cost from the Catastrophe
The cost will be high, and not all costs will be covered by insurers. For one thing, the cost involving the Coast Guard can be millions of dollars but according to the USA Today report, Coast Guard won’t charge people for search and rescue. as fear of costs could deter people from seeking lifesaving help. This means taxpayers will have to pick up a part of the bill.
I wonder if the insurers knew this before they issued a policy to OceanGate, although it is highly likely for any insurers who did the due diligence before issuing a policy to know this. It may even be a part of the contract that any rescue effort by the Coast Guard is to be excluded from insurance coverage.
Lawsuits Possible
As with many insurance cases, there are likely lawsuit(s) following the deaths of people and after more is learned about what exactly happened under the water in the near future. It doesn’t help that the submersible had previous battery problems. People may argue that the company had a negligent problem, which may be enough to weaken the power of any liability waivers the firm asked passengers to sign. Nonetheless, the AI is right that the importance of liability insurance can’t be denied, even for some of the richest people in the world.
The Takeaways:
- Most insurance agents never care to ask why the CD-type annuities, otherwise known as Multi-Year Guaranteed Annuity (MYGA), can offer higher interest rates than bank CDs (Certificate of Deposit) do. Lucky for them, most annuity buyers have never asked this question.
- This is a totally legitimate question because money does not fall from the sky but must come from somewhere somehow.
- Some say CDs have a shorter life duration than MYGA annuity contracts. However, this may or may not be true because we do have one-year MYGAs in the market and they still have higher interest rates than one-year CDs.
- The first crucial fact: CDs are offered by banks, while annuities are offered by insurers.
- The second crucial fact: Banks and insurers are subject to different regulations. For the most part, banks face tighter regulations than insurers do.
- Therefore, insurers have the liberty to invest premiums in a variety of financial products: Bonds, stocks, mutual funds, real estate and even financial derivatives. On the other hand, banks make money mainly from interest spread, the difference between the interest rate they pay depositors and the one they charge for loans.
A Financial Fact Deserving Explanation
There is a hidden question that most insurance agents never care to find out what the answer is. It concerns the fact that one of the most popular annuity contracts, Multi-Year Guaranteed Annuities or MYGA, almost always offer higher interest rates than bank CDs (i.e., Certificate of Deposit in case you are not familiar with banking terms) do.
Insurance agents love to sell MYGAs because it is a CD-Type annuity, meaning to keep the premium for annuity like keeping the deposit for CD, but with (much) higher rates. Agents will not miss the opportunity to ask their clients the question of how much interest they get from CDs — all because they can brag about how high the rate is for MYGAs in comparison with CDs. They won’t bother to tell clients why they can offer a higher rate.
Most of the time they run into no problem because, guess what, most annuity buyers don’t care about why they get a higher rate of return, either. It’s human nature that people do not bother to ask questions about good news, they will do about bad ones.
But when something most agents won’t do, it helps make you unique if you can answer the question right. Suddenly your image improves a great deal, and you may even receive voluntary referrals by some admiring clients.
The Simple Answer for MYGA Magic
It does not need a rocket scientist to figure out the MYGA Magic: MYGA is offered by insurance companies (insurers), while CDs are offered by banks. Of course, this may or may not make much difference until we know the difference between their business models (i.e., how they make money as an industry) and industrial specific regulations.
Turns out that insurers have more regulatory freedom than banks do. For one thing, insurers can invest the premium in a variety of assets, including bonds, stocks, and real estate, even financial derivatives, to generate returns. Banks on the other hand are required to maintain a certain amount of reserve and are limited in the amount of money they can lend out. They make money primarily by lending out money to borrowers and use the interest rate spread (i.e., difference between the interest rate they pay on CDs and the interest rate they charge on loans) to gain profit.
Some say MYGA has longer time to mature than bank CDs, but this may or may not be true. We have some insurers offering one-year MYGA and still with higher interest rates than bank CDs.
Next time when an insured asks his /her agent how they can afford to pay so much better interest rates than banks, I hope the agent knows the right answer.
The Takeaways:
- Double taxation is a tax principle where taxes are collected for the same income, assets or financial transaction at two different time or by different tax authorities.
- There are common cases of double taxation but also legitimate ways to avoid double taxation. Therefore, both double taxation and no double taxation are tax principles followed by tax authorities and/or expected by taxpayers.
- The best example of economic double taxation is corporate profits, which are taxed twice by the same tax authority, first at the corporate level and then at the individual taxpayer level when the profits are distributed to shareholders as dividends.
- The best example of jurisdictional double taxation is in international trade and/or international investment, where the same income or investment gains may be taxed by different countries.
- For insurance related income or investment, it is more likely to observe no double taxation than otherwise in the US.
I have been thinking of writing posts concerning taxation, for no better reason than the fact that insurance deals with two certainties in life: Taxes and deaths. Each is sufficiently complicated alone by itself, but when the two meet, things get outrageous. Since we can’t bypass them, we might as well study them to get smarter.
This post and other similar posts do not provide tax advice for individuals or entities. They are called “golden rules,” but they are really high level personal observations and thoughts from reading tax codes related to life insurance, annuities, property & casualty, and healthcare.
The Rule of (No) Double Taxation
This rule says we should avoid imposing and paying taxes twice on the same source of income, asset and/or transaction, either by the same or different tax authorities.
Here is the observation I have made from studying tax law: Although double taxation commonly exists, the US and local governments have made an effort to avoid charging double taxes, which I believe is a trend likely to be continued in the future.
In other words, both double taxation and efforts to legitimately avoid it exist at the same time. Correspondingly, we have seen discussions on “double taxation” as well as discussions on how to stop or avoid double taxation. This is healthy because we are seeing both sides of the coin.
What Is Double Taxation
Let us begin by defining what double taxation is.
The following definition is from an authoritarian source by Cornell Law School: “Double taxation refers to the imposition of taxes on the same income, assets or financial transaction at two different points of time.” This sounds simple and concise, and is used by Perplexity.AI in its answer to my inquiry.
To ensure multiple sources are considered, I will also cite the following definition by Investopedia.com: “Double taxation is a tax principle referring to income taxes paid twice on the same source of income.”
Neither definition did a complete job. The strength of the Cornell definition is to extend double taxation to cover not just income (like Investopedia did) but assets (e.g., capital taxes) and transactions (e.g., sales taxes). Its weakness is to limit double taxation to “two different points of time.” Finally, the word “imposing” indicates a tax authority perspective.
The truth is that double taxation can happen not necessarily at two different times but by different jurisdictions, sometimes at the same time or by the same due dates. This is the so called “jurisdictional” double taxations.
The strength of the Investopedia definition is to name it as a “tax principle,” while the Cornell definition just lists it as a phenomenon or a process. Its weakness is to limit the principle to “income taxes” only. Finally, the word “paid” signals a taxpayers’ perspective.
It has been frequently stated that double taxation falls into two types of economic and jurisdictional. I argue the former is more fundamental as economic consequences cut through all double taxation cases. On the other hand, some double taxation can be imposed by the same rather than different jurisdictions (e.g., different countries).
How Popular Is Double Taxation?
Perhaps the most famous example of double taxation is corporate profits, which are taxed at the corporate level and then at the individual level when the same profits are distributed as dividends to shareholders. This particular case involves a single jurisdiction or the same tax authority of the federal government, which taxes twice for the same profits.
More specifically, corporations pay taxes on their annual earnings. When a corporation pays out dividends to shareholders, the dividends generate tax liabilities, meaning shareholders who receive any dividends must pay taxes on them, this is when double taxation happens.
It is possible that this particular scenario of double taxation has been going on for too long that we may take it for granted. Let me use an analogue to show this is not always right.
We can consider how wholesalers and retailers pay taxes. It turns out that wholesalers are not required to charge sales tax to retailers because when a wholesaler sells to a retailer, that retailer is not the product’s end user. Therefore, the wholesaler does not have to collect sales tax on the transaction when selling to a retailer.
Using the same logic to corporate profits, it would mean the corporation should not owe any tax because it is not keeping the earnings but distributing them to shareholders, who are the end gainers.
Jurisdictional double taxation is more common. Every year when we file income taxes, every taxpayer must file for the federal and state and local municipal taxes — for the same income we earned in the year. This double filing practice is highly likely to continue in the future, which means we will see both federal and state (or municipalities) income taxes imposed on us.
Jurisdictional double taxation on income taxes can be justified in that each taxpayer presumably receives services provided by both federal and state or local governments. For example, national security is the responsibility of the federal government in the US, while insurance businesses are governed by state government.
At lower levels of government, things are less clear. For example, residents of municipalities pay county and city taxes, even though they receive direct or more perceivable services only from the city, less directly from the county. Because of this issue, sometimes city-county may have agreements for joint financing of services with city residents also financing part of the county share.
The most frequently discussed jurisdictional double taxation is in international trade or investment, where double taxation occurs when the same income is taxed in two different countries.
The Cases for Avoiding Double Taxation
As common as double taxation is, we have also seen the other side of the coin, where double taxation has been avoided legally. This, after all, is why I call “double taxation” and “no double taxation” both legitimate tax rules.
Let’s begin once again with the well-known example of business profits. It turns out that double taxation mainly affects larger corporations (the C corporates) that pay out dividends to shareholders regularly. This is because those corporations are taxed as separate legal entities. As the Motley Fool article points out, “C corporations are the only business structure that is taxed separately as a business,” while other legal structures exist to help you avoid double taxation, such as sole proprietorship, partnership, single member LLC (Limited Liability Company), and S corporation.
The magic words here are “pass through entities” that pay “pass through taxes,” which is a fancy way to say that the profits or losses of a business entity are not taxed at the entity level, but instead “pass through” to the business owner’s personal tax return, without having to owe corporate income tax.
For a hypothetical example, say you and your wife have a small firm that is an S corporation. Last year your firm made a profit of $80,000. In the eyes of IRS, an S corporate is not a separate but a “flow through” legal entity. Therefore, although you are still required to file an annual tax return with the IRS that report the income, gains, losses, deductions, credits, etc., of the corporation each tax year, that $80,000 can “flow through” to your personal tax returns — as long as there are fewer than 100 shareholders — and you owe nothing at the corporate level.
Since your S corporation was incorporated in California, the state also requires you to file an annual return with $800 minimum franchise tax, another example of jurisdictional double tax.
Even the best known jurisdictional double tax can be avoided. International double taxation can be mitigated by formulating trade treaties between nations, such as double taxation agreements (DTAs), with countries they trade with and using relief methods such as the exemption and foreign tax credit methods. I won’t get into details as my focus is not on trade but on insurance.
No Double Taxation in Insurance
Compared with cases of double taxation, there are far more cases of no double taxation in life insurance and retirement taxation. It is safe to assume that once you contributed money to your policy after paying income taxes, you have made a nonqualified contribution as your contribution is not deductible. Based on the rule of no double taxation, you won’t be charged income tax for the second time when you are taking the money out during the so called distribution stage. I will provide more examples later but suffice it to say that when it comes to insurance related incomes and contributions, we have reason to say there are far more cases of no double taxation than otherwise. is one of the fundamental principles that we must keep in mind when we think of tax matters.
The Takeaways:
- Independent insurance agents possess some unique advantages like bringing more options and choices to customers and often with lower premiums.
- Independent insurance agents tend to be more experienced with more industrial knowledge. Other things equal, they may also care more about clients’ welfare.
- Whether independent agents can provide impartial advice or serve clients better depends more on the individual than the group of agents.
- Independent agents should not push for switching providers without taking the switching cost into account.
I have officially declared myself to be an independent insurance agent this month and have been feeling good about it. But this morning it just hit me that I should have asked my favorite AI site of Perplexity.AI about why going independent is good choice not just for me but also my customers.
What the AI Site Says about Independent Agents
I entered this questions:
“What are top reasons insurance consumers should go independent insurance agents?”
Obviously this is a biased question as I only asked for the “pros,” not “cons.” But let’s see what the AI has to say. Below is the answer in its original form and shape:
“Independent insurance agents offer several advantages to insurance consumers. Here are some of the top reasons to go with independent insurance agents:
- More options: Independent insurance agents are not tied to one company, so they can shop around to offer you the best rates. This comparison can result in significant savings.
- Choice: Independent agents represent many different insurance companies that offer a wide variety of coverage options and price points. There’s no need for you to accept one quote from one company, and there’s no need for you to spend time filling out many different online applications to get your own quote comparisons.
- Better customer service: Independent insurance agents are more responsive to their clients’ needs and can offer better customer service than captive agents.
- Impartial advice: Independent agents can provide impartial advice since they are not tied to one company.
- Ability to switch providers and keep the same agent: Independent agents can help you switch providers while keeping the same agent, which can save you time and hassle.
- Tailor-made policies: Independent agents can put together custom-tailored solutions than meet your unique and particular needs.
- Lower premiums: Independent agents can often offer lower premiums than captive agents.
- Knowledgeable: Local independent agents are knowledgeable about the insurance industry and can help you find the right coverage for your needs.
My Overall Evaluation
In my view, the first two advantages, options and choices, are “no brainer” because they are the biggest and most obvious pros for insurance customers. Ask any independent insurance agent and most likely they will proudly tell you the story of better options and choices they can now bring to clients.
Point #7 of lower premiums also holds true most of the time, simply because of more choices than before. In the quote engines many platforms built for independent agents, we can easily see side by side how much premium different products from different carriers will charge, which would be hard to do for the captive agents.
A quick sidenote: “Captive agent” means someone working for a single insurance company or a single insurer or carrier, unlike an independent agent who will write insurance policies for many insurers at the same time.
Point #6 of tailor made policies to the clients is also more possible than a captive agent. When you have more options to choose from, you can compare them and sometimes can even ask carriers to customize the product to fit the customers’ needs and wants better.
So much for the pros and positive evaluations. The following points I feel uncertain with reservations.
Independent Agents & Customer Service
Point #3 that independent insurance agents provide better customer service may or may not be true. In my view, quality of customer service varies more by individuals than by group of agents (i.e., independent versus captive).
Many Independent Agents Are Experienced
Although independent agents may or may not do a better job in serving customers, I must add that they tend to be more experienced or more seasoned. My personal observation tells us that many independent agents started as captives and later after accumulating years or even decades of experience decided to go independent.
This agree with Point #8 that independent agents are more knowledgeable.
There will be exceptions of course. I myself haven’t done decades of insurance for example, although I do have years of teaching financial subjects, which certainly helps. At the risk of self-promotion, I’ve been told by others that I know more than many who have been with the industry for decades. I also know that some of the topics that interest me (e.g., how insurance as a whole makes money) may never interest others, no matter how long they have been in the business.
Having the right amount of curiosity is the key and may be all that you need in this age of AI, which makes the entire world of knowledge accessible to your fingertips.
Independent Agents Care About Customers
Other things equal, I’d say independent agents tend to care more about clients. My reasoning is this: If you take insurance as just another job that pays the bill, whether your clients get the best option they deserve does not really matter — as long as they get their commission. For someone who really cares, being able to offer substantial assistance to satisfy clients’ needs and wants makes a big difference.
I want to use myself as an example. I put three promises on my business cards and flyers:
- Your interest before mine.
- Preach only what I believe.
- Knowledge & insights before sales.
I must be honest that I haven’t seen many agents promising the same.
Independent Agents & Impartial Advice
Although independent agents have access to far more options or choices for customers than captive agents do, it does not automatically mean they are unbiased or impartial.
For one thing, not all products have the same commission or same commission structure. Because everything is transparent on agent portals or platforms, an independent agent can quickly see which option or product has higher commission for them — the information not typically seen by the clients. If they choose to, they can push for only those options that promise higher commission instead of what is the best for the clients.
Switching Products Incurs Cost
Finally, we come to Point #5 that independent agents can help you switch providers while keeping the same agent, which can save you time and hassle. I would be careful about switching providers because it typically comes with an extra cost, such as surrender charge, a cancellation fee and application cost by the new provider, which is typically a flat fee of $50 or 10% of your remaining premiums.
Of course, if you can find a new policy with a premium that makes up for any cancellation fees, it may still be worth it to switch. Another good time to switch is the policy renewal time, when you can normally find a better option by switching. Most if not all Property and Casualty policies are renewed every year (6 month for auto policies), one should take advantage of that to reconsider whether your insurance need has been met.
A permanent life policy may never expire or need to be renewed, while a term life policy will need to be renewed at the end of the term. Health insurance allows one to change provider during the annual enrollment period. Some insurance agents would encourage all potential clients to switch, but the cost question should always be asked ahead of time of switching.