Is now the perfect time for clients to dump their 401(k)/PSP?Article added by Roccy DeFrancesco on March 27, 2009
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Let me preface this article by stating that, when you practice law, you're ethically bound to give advice that's in your client's best interest. If your clients are small business owners, they're not the employees, the government, or some private interest group looking to protect the poor or downtrodden.
Conventional advice to build wealth
To many people, it makes logical sense that if you can defer income taxes now, you can create a larger retirement nest egg because you are using the government's money to grow your wealth.
If you are a business owner in the 35-percent income tax bracket, you can choose to income tax-defer, let's say $45,000, into a 401(k)/profit-sharing plan (PSP) that can grow tax-deferred for years; or you can choose to take home $29,250 after paying income taxes to invest for retirement. Business owners so despise the IRS that they cannot wait to income tax-defer the maximum amount of money into "tax-deferred" qualified plans.
Does that make sense? Let's look at an example with a 45-year-old small business owner who is now in the 35-percent current income tax bracket, and will be in the same bracket in retirement. The client will income tax-defer $45,000 into a 401(k)/PSP which will be compared to investing $29,250 after-tax in a brokerage account. Assume a 1.2 percent mutual fund expense on money in both accounts and a 20 percent blended capital gains/dividend tax on the annual growth in the after-tax brokerage account. Assume a 7 percent annual growth rate on both accounts. Finally, I will assume that the client will draw down both accounts from ages 66-85, where at age 85 both accounts will be zero.
Assume that our business-owner client has four employees earning $35k, $45k, $55k, and $75k a year and that, in order to "max-out" the qualified plan for the owner, a 6 percent across-the-board contribution must be made for the employees. The total employee compensation is $210,000 a year, and 6 percent of that is a $12,600 a year contribution. Let's also assume a $1,000 TPA fee to administer the 401(k)/PSP.
So, $13,600 x .65 = $8,840 (the amount the business owner could take home after-tax to build wealth if he/she didn't have to fund a qualified retirement plan for employees).
Which one will provide more after-tax income in retirement? Did you guess the income-tax-deferred qualified plan? Let's look at the "real-world" numbers:
*$38,090 = $29,250 + $8,840.
|Total account |
value at age 65
|Tax-deferred qualified plan||$45,000||$1,861,202||$150,892||$98,079|
That's interesting. When I factor in the actual costs of the employees, using an income-tax-deferred plan didn't work out so well.
Changing the variables
What if the example client has no employees and chose not to fund a tax-deferred retirement plan?
How much could be removed from the after-tax brokerage account? $78,095 (thus showing the power of income tax-deferring money for retirement).
What if the client has no employees and no tax-deferred retirement plan, is in the 25-percent tax bracket now and will be in the 35-percent bracket when in retirement? $90,100 (from the after-tax brokerage account).
Give your clients an excuse to dump their 401(k)/PSP
The recent stock market crash and the crummy economy, while not good for anyone, has opened up a window of opportunity for business owners to get rid of their qualified retirement plans. Few employees today would question an employer for getting rid of an employee-benefit perk right now. Most employees are happy to have jobs, and the chance of creating ill-will because of the removal of a retirement plan is slim.
If you think I'm the Grinch or Scrooge, please re-read my introductory paragraph to this article. If your clients are business-owners, you need to put forth various options for them to choose from, including the one(s) that are the most financially beneficial.
Funding cash-value life insurance after-tax instead of a tax-deferred qualified retirement plan
What if the example client funded revolutionary life in the amount of $38,090 every year after-tax for the same timeframe and removes the maximum amount of income tax-free loans from the policy from ages 66-85 (assuming a gross rate of return of 7 percent)?
How much could be removed from the policy?
You may recall that I created two separate illustrative software programs that compare using cash-value life to growing wealth in mutual funds and one that compares using cash-value life to growing wealth in a tax-deferred retirement plan.
- $166,010 (with wash loans each year from ages 66-85)
- $196,513 (with a 1.5 percent variable loan each year from ages 66-85)
What if the example client only placed $29,250 into revolutionary life?
Remember, $29,250 is the amount of after-tax money that would be available in the first example if the client had no employees and chose not to implement a tax-deferred retirement plan.
- $127,283 (with wash loans each year from ages 66-85)
- $150,788 (with a 1.5 percent variable loan each year from ages 66-85)
I'm not telling you that tax-deferred retirement plans are evil or bad. I'm a huge proponent of proper "asset allocation," so having a tax-deferred qualified plan for some or many clients can make sense. However, I'm also a proponent of advisors knowing the "real world" math on topics; so a discussion about the math can be had so informed decisions can be made about the best way to help your clients grow wealth.
*Circular 230 disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.
- If your employer clients have enough employees, the math is clear and that it will be counter-productive from a financial point of view to have a tax-deferred qualified plan.
- If your employee clients have no employees and choose between a tax-deferred plan and investing money after-tax into a brokerage account, a tax-deferred account will work out better.
- What the last set of numbers reflect is that one of the options you should put forth to your clients is funding cash-value life insurance after-tax (regardless of whether the client has employees or not).
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