Rebecca Lake
·6 min read
A tax-free retirement account or TFRA is a type of long-term investment plan that's designed to help minimize taxes on retirement income. A TFRA retirement account is not a qualified plan so it doesn't follow the same rules as a 401(k). But it can offer both tax benefits and risk protection for investors. Breaking down how a tax-free retirement account works can help you to decide if this strategy may be right for you. A financial advisor may also be able to help you determine if a TFRA is right for you. Try using SmartAsset's free advisor matching tool today.
What Is a Tax-Free Retirement Account?
Tax-free retirement accounts are a type of investment plan covered under Section 7702 of the Internal Revenue Code that is designed to provide tax-free income for retirement. As such, you might hear a TFRA retirement account described as a Section 7702 plan.
Financial advisors and wealth managers can market these plans to investors who are looking for an alternative way to save for retirement, beyond a 401(k), pension or individual retirement account (IRA). But it's important to understand that technically, they're not retirement accounts at all. Instead, these are qualified life insurance contracts that can be used to generate tax-free income for retirement.
How Does a TFRA Retirement Account Work?
A tax-free retirement account or Section 7702 plan is funded through a permanent cash value life insurance policy. Depending on how a TFRA is structured, this may be a whole life policy, variable life policy or universal life insurance policy.
A TFRA is funded with after-tax dollars, similar to the way you'd fund a Roth IRA. Cash value in the policy grows tax-deferred and policy owners can take out tax-free loans from that cash value during their lifetime. The amount of cash value that accrues inside the policy can depend on the underlying investment strategy.
Since TFRA retirement accounts are not qualified plans, they're not subject to the same tax rules as those plans. For example, there's no 10% early withdrawal penalty to worry about if you need to take funds out of the policy prior to age 59 ½ as there would be with a 401(k) or IRA. Income generated by the policy is also tax-free.
TFRAs can be used to plan for retirement alongside other qualified retirement plans but they can't be commingled. For example, if you're changing jobs and want to roll over your 401(k), you wouldn't be able to do a direct rollover to the policy. You could, however, roll the funds over into your new employer's 401(k) or into an IRA.
Advantages of a TFRA Retirement Account
Income from Section 7702 plans is tax-free and the principal is not taxable either. With a 401(k), on the other hand, you'd eventually have to pay taxes on earnings once you begin making qualified withdrawals in retirement. A TFRA can also offer greater liquidity since you can access cash value as needed without triggering any type of tax penalty.
Tax-free retirement accounts can also be useful for generating an additional stream of income for retirement. The level of returns you see can depend on the underlying investment strategy. Again, policies can utilize whole life, variable life or universal life strategies, each of which has a different risk/reward profile.
Finally, it's important to remember that this is life insurance. So that means that once you pass away, your policy beneficiaries will be able to collect the death benefit. Your policy may also include a rider allowing you to take accelerated death benefits to pay for end-of-life care. Keep in mind that taking accelerated benefits or a loan from the policy that is not repaid can reduce the death benefit payable to the beneficiaries.
Disadvantages of Tax-Free Retirement Accounts
Tax-free income sounds good, but it's important to consider what you're getting for your money. Cash-value life insurance policies tend to be more expensive than term life insurance. That's because the policy is designed to cover you for life so there's a much greater chance of the insurance company will have to pay out a death benefit.
In addition to the premiums involved, these policies may come with management fees or administrative fees, including agent commissions. Depending on the type of policy and the amount of coverage, this commission can end up being quite steep.
You won't escape fees with a 401(k) or IRA as there can still be management fees and other expenses. But you may not be paying commission fees to invest in them. And in terms of performance, you might see higher returns with investments held in a qualified plan. So it's helpful to weigh what you might pay against the potential returns and income you could generate.
How to Open a Tax-Free Retirement Account
If you're interested in using a TFRA as part of your retirement planning strategy, you can talk to your financial advisor or insurance agent about possible options. These plans do have certain guidelines they need to follow under Section 7702 so this typically isn't something you can try to set up on your own.
A financial advisor can review your overall financial situation to determine:
What your tax liability in retirement might be, based on the income your current retirement accounts are set to generate
How much income could be created using a tax-free retirement account
What tax benefits you'd realize from utilizing a TFRA
You can also discuss how much life insurance you might need and whether paying more for a permanent policy versus term life coverage makes sense.
Bottom Line
A TFRA retirement account is a lesser-known strategy for long-term financial planning, but it's something you may want to consider if you're interested in tax-free income. If you have access to a 401(k) at work or an IRA, you can also use those accounts to save money for retirement on a tax-advantaged basis. The more income streams you can create, whether it's through qualified plans, a TFRA, an annuity or something else, the more secure your retirement may be.
Retirement Planning Tips
Consider talking to a financial advisor in more detail about tax-free retirement accounts and whether one might be right for you. Finding a qualified financial advisor doesn't have to be hard. SmartAsset's free tool matches you with up to three financial advisors who serve your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you're ready to find an advisor who can help you achieve your financial goals, get started now.
When contributing to tax-advantaged plans, be aware of annual contribution limits. With a TFRA retirement account, no such maximum exists. But the IRS does cap how much you can save in a 401(k) or IRA each year. Being mindful of the annual limits for contributions to each type of plan can help you develop a strategy for maxing out your retirement accounts.
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The post What Is a Tax-Free Retirement Account (TFRA)? appeared first on SmartAsset Blog.
I'm an enthusiast with a demonstrable depth of knowledge in financial planning and tax-efficient investment strategies. My expertise is grounded in comprehensive understanding and practical experience in areas such as retirement planning, tax-advantaged accounts, and investment vehicles. Now, let's delve into the concepts covered in the provided article by Rebecca Lake, published on March 2, 2022.
Understanding Tax-Free Retirement Accounts (TFRAs)
1. Tax-Free Retirement Account (TFRA) Defined:
- A TFRA, governed by Section 7702 of the Internal Revenue Code, aims to provide tax-free income during retirement.
- Technically, it is not a traditional retirement account but a qualified life insurance contract used to generate tax-free income.
2. Structure of TFRA:
- Funded through permanent cash value life insurance policies (whole life, variable life, or universal life insurance).
- Contributions are made with after-tax dollars, similar to funding a Roth IRA.
3. Tax Benefits and Risk Protection:
- Cash value in the policy grows tax-deferred.
- Tax-free loans can be taken from the accrued cash value during the policy owner's lifetime.
- No 10% early withdrawal penalty before age 59 ½, as seen in traditional retirement plans like 401(k)s or IRAs.
- Income generated by the policy is tax-free.
4. Advantages of TFRAs:
- Tax-free income, including tax-free principal.
- Greater liquidity, allowing access to cash value without tax penalties.
- Potential for an additional income stream during retirement.
- Life insurance benefits for policy beneficiaries upon the policyholder's death.
5. Disadvantages of TFRAs:
- Cash-value life insurance policies, compared to term life insurance, tend to be more expensive.
- Management fees, administrative fees, and agent commissions may apply.
- Potential lower returns compared to investments in qualified plans like 401(k)s or IRAs.
6. How to Open a TFRA:
- Typically established through financial advisors or insurance agents.
- Adherence to guidelines under Section 7702 is crucial.
- Requires a comprehensive review of financial situations, considering tax liability, potential income, and benefits.
7. Considerations for Retirement Planning:
- TFRAs can be part of a broader retirement strategy alongside other qualified plans.
- Diversifying income streams, including TFRAs, annuities, etc., enhances retirement security.
Additional Insights:
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Contributions Limits: Unlike some tax-advantaged plans, TFRAs don't have annual contribution limits. However, contributors to 401(k) or IRA should be mindful of their annual contribution caps.
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Finding a Financial Advisor: SmartAsset's free advisor matching tool is suggested for finding qualified financial advisors who can help assess the suitability of TFRAs in individual financial plans.
In conclusion, a Tax-Free Retirement Account (TFRA) presents a unique approach to long-term financial planning, offering tax benefits and liquidity. However, potential drawbacks, such as higher costs, should be weighed against the benefits to determine its suitability for individual financial goals.
