Chapter 7
Taxes and Insurance


Understanding how taxes have been used to support civilizations over the course of modern history can help you realize how important they are to us today as U.S. citizens. While some people may take the viewpoint that fewer taxes or more taxes is better, the following summary will help you as you sift through your own opinions about taxes and the benefits to our society.

Did you know that the earliest income tax was implemented in Mesopotamia over 4,500 years ago, where people paid taxes throughout the year in the form of livestock? The ancient world also had estate taxes, or “death taxes.” The earliest recorded evidence of a death tax comes from ancient Egypt, where they charged a 10 percent tax on property transferred at the time of death in 700 b.c.1

Since then, the way we pay taxes has changed significantly. However, some ancient taxes still persist in the modern world. In 2006, China eliminated what was the oldest still-existing tax in history. An agricultural tax was created 2,600 years ago and was eliminated in order to help improve the well-being of rural farmers in China. In the United States, the tax system evolved dramatically during the nation’s history. The federal government first imposed income taxes in 1861 to help pay for the Civil War.

Before the 1860s, the government got by on taxing imports and exports. But with the significant cost of the Civil War burdening the treasury, the government enacted a tax rate of 3 percent on incomes above $800, and 5 percent for incomes above $10,000. These measures were short-lived, and the laws were repealed in 1872. American citizens didn’t pay income taxes for the next 20 years.

With the onset of World War I, the federal government again needed to raise revenue quickly, and in 1918, legislators raised the rates sharply, particularly on high-income citizens: 77 percent on incomes over $1 million. The marginal tax rate went down slowly over the following 20 years, but it went back up during the Great Depression, since fewer people had any taxable income.

As the nation emerged from the Depression, the New Deal brought new benefits for citizens—and a new type of tax. In 1937, under the Roosevelt administration, Congress ratified the Federal Insurance Contributions Act (FICA), and FICA taxes funded the Social Security Administration. When Medicare passed in 1965 under the Johnson administration, FICA taxes increased to cover program costs. FICA is a flat tax, a standard percentage that everyone pays up to a set maximum. But income taxes are subject to various changes at different income levels. The marginal tax rate stayed high all the way through World War II, when it went as high as 92 percent. (It has continued to go down over the years to a low of 31 percent in 1992, and it now stands at 35 percent.)

During World War II, the new tax policy added a feature that we accept as routine these days: income tax withholding. Before World War II, most people paid their entire tax bill on the tax due date, which put a significant strain on the government’s bank account. To end the feast-or-famine effect on the nation’s coffers, payroll-withholding laws have evolved and now require citizens to pay at least 90 percent of expected taxes due by the end of the year.2

Our taxes pay for education, roads, and national defense, among many other things. As our population has gotten older, more and more of our overall budget funds entitlement programs like Social Security. Those costs are only going to continue to rise, yet we have fewer taxpayers in the system. The reality is that as America’s age wave has hit, a higher percentage today is going to the entitlement programs.

Total Federal Spending 2015: $3.84 Trillion
Social Security, unemployment and labor $1.28 trillion 33%
Medicare and health $1.05 trillion 27%
Military $609.3 billion 16%
Interest on debt $229.2 billion 6%
Veterans benefits $160.6 billion 4%
Food and agriculture $135.7 billon 3%
Education $102.3 billon 3%
Transportation $85 billion 3%
Housing and community $65.5 billion 2%
International affairs $50.2 billion 1%
Energy and environment $44.8 billion 1%
Science $29.8 billion 1%

Source: OMB National Priorities Project.

The bottom line is that it is important for each of us to know the tax system, how we are personally affected, and what we are obligated to pay. We don’t need to have Uncle Sam as an active participant in our lives; we just need to abide by the current tax system. Too many people try to pay less in taxes and try to figure out all the schemes to game the system. But, seriously, that really shouldn’t be the way we look at taxes. Taxes are necessary, plain and simple. Think of it this way: The more you pay, the more fortunate you are overall. Don’t spend your time and energy on tax loopholes because they might catch up to you and won’t benefit you as you had hoped. Just understand the tax code, or hire a Certified Public Accountant, and pay what is required of you. Pay the piper and move forward with your life.

We all recognize that there is a cost to infrastructure and to the many things that makes a society function well. Ben Franklin said that in this world nothing is certain except death and taxes. That is why you must research your personal situation, and determine what sections of the tax code apply to you, especially when you look at your retirement planning.

Of course, you should not pay more taxes than is really fair or due from you. Arthur Godfrey famously said, “I am proud to pay taxes in the United States. The only thing is, I could be just as proud for half of the money.” The point here is to pay your fair share and be proud that you did.

How to Calculate Your Effective Tax Rate

Most people are familiar with the marginal tax rates, the rate at which your income is taxed for each tax bracket in which you qualify. However, more important is your effective tax rate, which is the actual percentage of your income you are actually paying to the IRS.

So, how do you calculate your effective tax rate? The following three steps may help out.

  1. Take your total income from all sources, including interest, capital gains, and dividends (Form 1040), and add any other amounts received, but not required, to be reported to the IRS.
  2. Now look at the total income taxes paid that year.
  3. Divide the taxes paid by total income.

I suggest that you work with a skilled CPA who can look at maximizing your tax deductions and credits, and utilizing the tax code to your benefit while staying within the confines of the law.

Judge Learned Hand, United States District Court for the Southern District of New York and, later, the United States Court of Appeals for the Second Circuit, may have said it best: “Anyone may arrange his affairs so that his taxes shall be as low as possible. He is not bound to choose that pattern which best pays the treasury. There is not even a patriotic duty to increase one’s taxes.”


We all recognize that there is randomness in life. Sometimes bad things happen that we can’t foresee. If there is a possible financial loss that could be so astronomical that it could destroy a person’s security, then the risk should be transferred to a third party. In those situations, it is important to transfer that risk to another entity, like an insurance company, so they can manage the risk with a larger pool of individuals.

In this section, we’ll talk about managing risk. Properly managing the risks in your life will provide a solid foundation for your overall financial plan. Failure to manage risks can jeopardize all other aspects of your finances, including your investments and retirement plans.

The first step in the risk management process is identifying areas in your life that might cause you to experience a financial loss. The second step is determining how to manage those risks.

There are four methods of handling risk:

  1. Retain risk: You choose to bear the full financial burden in the event of a loss.
  2. Reduce risk: You restrict the conditions that can create a loss.
  3. Avoid risk: You decide not to participate in risk-creating activities.
  4. Transfer risk: You purchase insurance to help cover a loss

If you can’t afford to replace it, if it were to be lost, damaged, or destroyed, then you should explore ways to transfer the risk.

For an example: Let’s say that a student works all summer to save up for a laptop for school. Upon buying the laptop, the vender asks if he would like to protect the purchase by insuring it. If the student is in a financial position where they could not afford to replace the laptop if it were to be damaged, he or she may want to consider paying a little extra to buy protection.

If, on the other hand, the laptop were to be damaged and the cost of buying a new laptop would not create financial hardship, then you are better off retaining, reducing, or avoiding certain activities, as opposed to transferring the risk by buying the protection plan.

In this book, I am going to focus on the last risk. While the first three methods are potential options, transferring risk offers a level of protection that the other three just cannot in most cases. Transferring risk means buying insurance: health insurance, life insurance, disability insurance, or auto insurance. On a macro basis, insurance companies manage a pool of risk by collecting premiums and quantifying how many claims they will have to pay out. They run their numbers to determine the premium they need to charge based on the frequency of a loss in order to have enough reserves to pay when that loss takes place while still collecting a premium and profiting.

Let’s talk about six kinds of insurance and the ways you can use them as part of building your financial foundation. We will talk about health insurance, long-term care insurance, life insurance, disability insurance, auto insurance, and homeowner’s insurance.

Health Insurance

As we all know, health insurance is an important topic and issue today. If an individual doesn’t have health insurance and is diagnosed with a terminal illness, they could have millions of dollars set aside, yet their treatment could potentially exhaust their entire savings and investment accounts. So, it’s crucial to have enough health insurance to protect against a catastrophic illness.

Many people rely on employer-sponsored health insurance plans, but often you still need to have savings set aside for health expenses with the rise of high-deductible health care plans. These types of plans require greater out-of-pocket payments as employers shift the increasing burden of health costs onto their employees.

No one plans to get sick or hurt, but most people need medical care at some point. Health insurance covers these costs and offers many other important benefits. Now more than ever before people have options for health insurance to protect their finances should medical emergencies or issues arise.

Long-Term Care Insurance

When it comes to long-term care insurance, we recognize that more and more people in their lifetimes will most likely find themselves in an assisted living facility, or in need of a caregiver to help them with their day-to-day activities. That can be a great financial burden to absorb. It may be wise, especially if dementia or Alzheimer’s runs in the family, to consider having at least a long-term care policy that can pay a small dollar amount per day for your care.

I tell clients that in retirement, there are three stages: The go-go years, the slow-go years, and the no-go years. During the go-go years, you will be spending your time and energy on everything that you wanted to do in life but did not have the time or money for. These will be your peak spending years in retirement. I often hear from clients that their go-go years are some of the most enjoyable years of their lives. Every day is a Saturday and they can spend every second doing whatever fulfills them as an individual.

Then you may slowly transition into the slow-go years. Still people are active during this time period, it’s just they are not moving as fast. It becomes much more about quality of time, rather than quantity.

Last comes the no-go years. It is during this time period that we want to appropriately assess your physical and mental needs and plan for your care. Spending in all areas, except healthcare, slows down dramatically during the no-go years. It is during this time period that having a long-term care policy may make sense. It can help with the costs of your day-to-day care. From bathing to feeding to cleaning to cooking, inside a facility or at home, a long-term care policy can reduce the monthly financial hardship that this stage of your life can present. It is wise to not assume that a long-term care policy will cover all your costs; that is unrealistic. Instead you should look at a long-term care policy to take the edge off the financial burden and keep your finances in the black.

For many people younger than 50, long-term care insurance seems like something to defer to the future. But similar to a term life insurance policy, the earlier you lock in a long-term policy, the less it will cost over the long haul. Another incentive to start young with long-term care is the greater likelihood you’ll qualify. The requirements get stricter and the policies get more expensive as you age. The best way to make the decision as to when to buy long-term care insurance is to have an honest dialogue with your financial planner.

In some cases, individuals may have enough in assets to become self-insured. In this scenario, even factoring in the cost of your day-to-day care would be less than the amount of income your assets are producing for you on a regular basis. As I mentioned at the beginning of the chapter, if you can manage and control the costs of this stage of your retirement without needing insurance, then the need to transfer that risk is not present.

Life Insurance

If you are the primary breadwinner and/or have small children at home, your spouse and children could have great financial difficulty if you pass away unexpectedly. To safeguard against this possibility, you need to have insurance coverage substantial enough to cover the mortgage, putting the kids through school, and other expenses to ensure your family can maintain their lifestyle.

Research from Voya Financial’s “Voya Retire Ready Index” found that only 18 percent of workers have more than $500,000 in total life insurance coverage. When you think about what it would cost to replace your income and support a family over many years, this generally is not nearly enough to ensure financial security.3

Your family will be suffering emotionally and you don’t want them to suffer financially at the same time. You pay the premium for life insurance and have the reassurance that if something happens to you, there would be enough money coming into the household federal- and state-tax-free to help your family continue moving forward financially.

As your need to cover expenses goes down, the need for life insurance may also go down. Conversely, if your expenses go up, your life insurance needs will increase as well. That’s really the essence of it. You may need life insurance while the children are young, but the need may decrease as your children age and you have more savings and fewer expenses to cover. Simply, you buy insurance when you can’t afford to replace that which might be irreplaceable.

Types of Life Insurance

There are two types of life insurance: cash value policies and term insurance. The trick is to decide which type is best for you.

Term life insurance has no cash value. Your premium payments pay for the cost of the insurance, and your beneficiaries will receive a lump sum payment (called a death benefit) only if you die. You pay the premiums for a period of time and are covered during that term (thus the word “term” life insurance). As retirement approaches, your need for life insurance is likely to decline, as children become able to support themselves and retirement savings come into play. At a certain point, you can drop your term insurance without penalty. Because there is no cash value component, term life insurance premiums are typically lower than cash value premiums.

On the other hand, cash value policies fall into a different camp than term life insurance and serve an additional and valuable purpose. These policies are permanent in nature and the cost of insurance is based on your entire life expectancy. Here is how it works: You make a payment every month for the cost of the insurance, and there is an extra amount going into a separate account that creates cash value for you. The cash value portion of the policy can become a valuable and flexible financial tool for you after it accumulates. In many cases, the cash value can be borrowed against and paid off eventually at your death, when the life insurance death benefit is paid out. The borrowed money is subtracted from the death benefit, creating a nontaxable exchange.

Remember that cash value policies are typically more expensive than term insurance. When you buy term insurance, you’re covering your liability for a specific number of years. After those years have been completed, the term insurance expires and then you either go without insurance or have to buy a new insurance policy.

Some individuals look at life insurance begrudgingly, and don’t want to consider it an investment. They want to pay the least amount for coverage. They know they’ll need that coverage for the next 15 or 20 years as their kids are getting older, or until they determine they have enough money to be financially independent. If this sounds like you, you may lean toward buying term life insurance. As one’s net worth increases and expenses decrease, the need for life insurance may decrease as well.

Disability Insurance

What would you do if you were not able to work for three months? Six months? A year? Longer? This is a scary prospect for any professional. Disability insurance helps protect against financial loss due to an inability to work, offering income protection against injury, illness, or any condition that might cause physical impairment or incapacity to work.

If an individual owns his or her own business and is worried about the possibility of becoming disabled, there is an option of buying a disability policy that will pay while the business owner is not able to work. I work with a client who is a successful doctor who runs his own family practice. His staff, family, and patients depend on him to be healthy and to be able to work. In his case, he purchased a disability policy that can keep his business operating if he were to become disabled. It would also pay him a specific dollar amount per month until he reaches full retirement age.

Americans use insurance to protect a host of assets, from cars to homes to jewelry. But many people forget to insure their most important asset—the ability to work and earn a living. Social Security states that, “Just over one in four of today’s 20-year-olds will become disabled before reaching age 67.” And if disease or injury renders you disabled early in your working life, the lost wages can be worth much more than a house or a sedan.

While the Social Security Administration does provide a small amount of disability benefits as a safety net, it is a small amount of help and will likely not be enough to cover your shortfall needs. In addition, there is a complex eligibility process, and benefits apply to Americans with a medical condition that prevents them from working for at least 12 months. If the prospect of losing just a few months’ income or living on a fraction of your paycheck just isn’t an option, you will want to seek out some form of disability insurance to protect yourself. Your employer (or your spouse’s employer) may offer a group disability insurance plan or you could research and secure an individual disability plan. Start by speaking with your human resources department or benefits coordinator at work. If you are self-employed, then go online and research individual policy options or speak with your financial planner.

Automobile Insurance

The law now requires that every car has its own insurance policy, if for no other reason than to protect other people from your mistakes. Of course, you can get more comprehensive coverage that protects you from other people’s mistakes. In other words, this means protection against the underinsured and the noninsured, which is crucial. Of course, within the auto policy, the coverage helps with the repairs of the car after the deductible is satisfied.

Automobile insurance companies will be aggressive in competing for your business, and while the process of comparing cost and benefits might feel overwhelming at times, it is important to sift through your options and decide if the lowest cost provider is the best way to go. There is no one right solution and no single best insurance provider. Your driving record, age, gender, where you live, what kind of car you drive, and many other factors affect your premium. As a starting point, do your research online and ask each insurance carrier what kind of discounts they will give you based on the factors noted above. Also consider the carrier’s payment record (some are known to throw up road blocks and deny or draw out the claims process). Others have a history of raising a driver’s premiums after just one claim. Use online forums such as Yelp or Angie’s List to learn from other people’s experiences.

Renters or Homeowner’s Insurance

Renters or homeowner’s insurance is also called hazard insurance. This is a type of property insurance that covers a private residence. It is an insurance policy that combines various personal insurance protections, which can include losses occurring to one’s home, its contents, loss of use (additional living expenses), or loss of other personal possessions of the renter/homeowner, as well as liability insurance for accidents that may happen at the home or at the hands of the homeowner within the policy territory.4

Usually within the homeowner’s insurance there is a limited liability umbrella policy. You could buy a million-dollar umbrella policy that would cover most types of liability. If a friend or neighbor jumped on your trampoline, fell, and broke their arm, or slipped and fell on your icy steps, your policy would help cover any costs associated with those accidents. An umbrella policy is quite cost-effective. The insurance carrier wants to make sure that you are not at fault if you get sued. If you are at fault, then the insurance carrier must pay that claim. What’s interesting is when someone has an umbrella policy and there is some type of suit filed against them (i.e., auto accident) and the insurance is maxed out from the auto insurance, the excess may flow into the umbrella policy.

In case of a claim, insurance carriers will have their own attorneys investigate the case with the hope that they don’t have to pay more than necessary. Many times, when people have an umbrella policy, they also receive the legal support from the insurance carrier providing that insurance. That’s really quite important. Unfortunately, we live in an environment where some people just want to take from what others have built. And, in a litigious society, some are “sue happy.” You really must have an adequate amount of insurance to protect yourself against the world.


Deductibles, in essence, lower the cost of the insurance itself. The higher your deductible, the lower your premiums will be. Using the example of an automobile insurance policy, let’s say you have a deductible of $500 on all of your vehicles. You pay the heavy premium to have that low deductible. So, the first $500 is out of your pocket and then everything above that the insurance carrier will pick up. Using this theoretical scenario, think about this: If you were to get into a little fender bender and you backed up into someone, you would be liable for it. You have a deductible of $500, but the damage was $750. Would you submit that claim?” You might think to yourself, “Well, if I submit that claim, the first $500 comes out of my pocket, so then the insurance company will pay $250.”

Usually there is a very real possibility that your premium may increase because of the accident. Insurance carriers figure that if you’re in one accident, the probability of you being in another accident is now higher. So, then you may think, “Well, I don’t want to pay a higher premium just because they’re helping me with $250.” So, you may need to consider at what point you need to transfer the risk to the insurance company, then raise your deductible to that point. Think of it this way: with a deductible of $500, you may be paying for insurance that you will never use.

Overinsured or Underinsured?

Some people are overinsured and have far too much insurance based on their needs and liabilities, although this is not the common situation. Other times, and more often, people can be completely underinsured. In order to determine how much coverage you need, you should quantify your expenses. If you are insured appropriately, you don’t have to be afraid of your own shadow. You can go out and live your life. If you do suffer a catastrophic event, you can be assured, at least financially, that you won’t be alone and you will have the support you need in a difficult time.

You can look at insurance policies as being like the side rails on a bridge. If there were no side rails on a bridge, we all probably would be driving across the bridge at one or two miles an hour. If there are side rails on the bridge, then we know that we would have to hit that side rail pretty hard for us to go off the bridge and hurt ourselves. It just gives us enough support and enough structure so we don’t focus on the dangers of driving on the bridge, but rather on getting to the other side.

A Defensive Strategy

In Chapter 6, we talked about asset allocation and how bonds can be a defensive strategy when included as a part of an investment portfolio. One could look at insurance as part of a defensive strategy for the rest of your life. You have insurance coverage in place to help your financial situation in those unfortunate situations where you are exposed or liable. By having adequate insurance you are, in essence, protecting your net worth and your family in case you are exposed to the unfavorable randomness of life.

What’s Ahead?

In the next chapter, we’ll talk about transferring the assets we don’t use during our lifetimes to loved ones and/or other beneficiaries.


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