At some point Congress will be forced to take action to fix our broken Social Security system. I believe that at least part of the solution will come in two parts. If I am correct, there is even more reason to talk to your clients about Indexed Universal life insurance today.
The first will be to apply a “means test” designed to reduce or eliminate Social Security benefits for retirees with higher income. The second part will be to increase the taxation of Social Security benefits. And the burden of these higher taxes will again fall on the shoulders of those with higher incomes.
We have already seen the introduction of means testing with the Medicare Modernization Act of 2003. That law established a means test that resulted in larger premiums paid by higher-income recipients for Medicare premiums for doctors and for prescription drugs.
What should be of interest to advisors and their clients is that the means testing for these benefits is based on a person’s previously filed tax returns. In other words the amount of income that appeared on a prior return would determine the amount of premiums the person would pay for these Medicare benefits. This means that the greater the income a person tax return reports as coming from things like withdrawals from traditional IRAs, 401(k)s and other tax deferred retirement programs the lower the potential after tax benefit from Medicare.
It does not seem such a radical assumption that we would ultimately see the same type of means testing applied to the Social Security retirement benefit. And it is logical to assume that the government would take the same approach of using the income on prior year’s tax returns to determine if a person should receive a reduced benefit.
Currently up to a maximum of 85% of a person’s Social Security income is taxable. It does not seem such a radical assumption that ultimately the taxable portion will increase from the current 85% to 100%.
Given the current rhetoric commonly used by politicians for increasing taxes on the rich it is easy to see a future where higher-income earners will face the double-whammy of paying higher taxes on reduced Social Security benefits.
Not Enough Rich People
The problem is that there are not enough rich people in our country for these changes to come close to actually fixing Social Security.
Anyone paying attention to how politicians operate should be able to see how this will all play out. It will start with politicians telling the masses about how unfair it is for the rich to receive the same amount of Social Security income as the poor especially when the program can’t afford to continue paying benefits at the present levels to both groups of people. It will be proposed that all we need to do to fix the program is to require the rich to take a small cut in benefits which they can easily afford and is the “fair” thing to do. Next we will hear that if this is not done then the entire program will collapse and all hard-working middle income Americans will retire in poverty. Above all, the promise will be repeated that the cuts will only effect the wealthy. The legislation will pass and soon after every middle income American with too much income reported on their tax return will find that they were the people who the politicians were referring to when they talked about the unfairness of rich people collecting benefits.
Once the maximum taxable portion of Social Security is increased from its current level of 85% to 100% the only way left for the government to get more of this money without increasing everyone’s tax rates will be to reduce the income thresholds that determine the taxable portions of Social Security.
The current thresholds require that single people receiving at least $34,000, and married people receiving at least $44,000 or more pay taxes on 85% of Social Security. In order to get voters to accept an increase in the taxable portion to 100%, the politicians might initially promise that the increase will only apply at the higher income thresholds. Later these thresholds will either be reduced or the long-term effects of inflation will simply place more of our clients in the upper thresholds.
It is important to note that these thresholds have never been indexed to inflation so it is inevitable that one day all of us will have incomes that exceed the top threshold.
For many of us, the best strategy for managing the risk that benefits will ultimately be means tested and 100% taxable may be to legally give the appearance of being poor.
One of the magical things about borrowing cash value from a non-MEC life insurance contract is that the borrower is not required to report the proceeds of those loans on their tax return. In fact, there is no place to enter them on a tax return even if a person wanted to. Life insurance companies are not required to send a 1099 to the policy owner or the IRS regarding these loan proceeds.
This means that if Social Security benefits were means tested or the taxable portion of these benefits were increased, under current law our clients could enjoy the proceeds from any cash value loan from a non-MEC contract, regardless of the amount without impacting their Social Security in a negative way.
Our client’s tax returns can legally provide the appearance of being poor while cash value loans allow them to live rich!