There are three buckets of money on people’s financial models and they are taxable, tax deferred, and tax-free. Obviously, the goal would be to have as much money in the tax-free area as possible. With tax favorable treatment, the government will put limitations on how much you can put int he tax deferred and tax free buckets. There is no limitation on the taxable bucket as they want to collect as much current tax as possible.
Most people feel that tax deferred is the greatest thing in the world, but it is not all good. When something is tax-deferred it means that the tax is deferred to be paid later. Once the 401k or pension plan compounds for many years, there is also a very large tax bill. In other words, if you have 1 million dollars your net will be about 30 to 40% less after taxes. In bucket number 3 which is tax-free, you have limitations in regards to how much you can put in. The two main tax-free items are permanent life insurance and Roth IRA’s. Both of them are limited in terms of how much money can be put in on a yearly basis. With life insurance, each policy has a MEC limit that is the maximum that can be put into the policy and remain tax-free. If you put money above the MEC limit in the policy then you will be taxed on the gains. A Roth allows you to put only so much money in per year and then if you earn too much you can’t start one. If you can learn how to use the cash value of the life insurance through withdrawals up to cost basis and through preferred policy loans, you can avoid paying taxes on the gains.