Should your clients tax-defer money into qualified plans/IRAs?, Pt. 2Article added by Roccy DeFrancesco on March 10, 2009
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In part one of this series, I alluded to the fact that tax-deferred qualified plans may not be the most efficient and safest way to build wealth (actually, they can be quite tax-hostile). I indicated that a better wealth-building tool with unique and protective characteristics is revolutionary cash-value life insurance.
The question we are examining today is: Should clients use cash-value life insurance (RL) to build a retirement nest egg instead of a tax-deferred 401(k) plan or IRA?
This is really the million-dollar question in the financial services field. If you ask someone who is intellectually honest with themselves and their clients, the answer will be, "It depends" (and this is almost always the answer).
The undisputable numbers
As I hinted at in my last article, I have just created a new online software/illustration/sales system that allows advisors to run the "real" numbers when determining if using life insurance is a "better" tax-favorable, wealth-building tool than a tax-deferred 401(k) plan or IRA.
Not to pat myself on the back, but it's really cool to be able to create real-world illustrations for clients and be able to tweak them with the many variables that need to be accounted for. What variables do I take into account?
|Length of contribution||21|
|Annual rate of return||7.0%|
|Mutual fund expenses||1.2%|
|Wrap fee /Money mgmt fee||0.0%|
|Present income-tax bracket||35%|
|Capital gains/Dividend (tax on growth)|| 20%|
|Retirement income-tax bracket|| 35%|
|Capital gains/Dividend (tax on growth)|| 20% |
|Begin withdrawal at age|| 66%|
|Years to withdraw|| 20%|
Use the numbers from the above chart. Keep in mind that if the client is in the 35-percent tax bracket, he/she must fund $5,250 into a side fund every year that he/she is funding $15,000 a year into revolutionary life (again, for a breakdown explaining all the variables, including the side fund for this example, please click here).
Here's the comparison for this example:
$15,000 every year tax-deferred into a 401(k) plan + $5,250 into an after-tax side fund/brokerage account vs. $15,000 every year into revolutionary life.
Then the question is: Which one provides more after-tax retirement income?
If you had to guess, you'd probably say the tax-deferred 401(k) plan + the after-tax side fund brokerage account because more money is available to grow. If you guessed that, you'd be wrong nearly every time.
Using this new illustration system, however, you'd get the following numbers:
|Annual after-tax retirement income by plan|
|Total||Qualified plan||Side fund|
The $32,693 is the after-tax amount that would come out from the tax-deferred qualified plan every year assuming the client is in the 35-percent tax bracket in retirement. The $14,017 is the amount that would come out of the client's after-tax brokerage account, or side fund, every year for a total of $46,710.
If the client simply funded $15,000 after-tax into revolutionary life from ages 45-65, how much would he be able to remove tax-free from ages 66-85?
And the winner is...? Cash-value life insurance! There is a huge difference between $46,710 and $56,710, $63,257 and $70,373.
- $56,568 (assuming wash loans)
- $63,257 using a 1-percent positive variable loan spread
- $70,373 using a 2-percent positive variable loan spread
After playing with my new illustration/sales system, I can tell you that revolutionary life, using reasonable assumptions, will almost always come out on top (unless the client is older than age 55 and can't wait enough years to allow his cash to grow).
Additionally, revolutionary life has the following positives:
So, should all clients abandon funding tax-deferred 401(k) plans and IRAs? No. Even though I've created a software system that makes the honest numbers dance and uses reasonable real-world numbers that show that cash-value life insurance will be a better retirement tool for the majority of clients, my answer is still no.
- The cash in the policy will not go backwards when the market goes down
- The gains are locked in when the market goes up
- The client has a death benefit to protect the family in case of an early death
- The client has a free long term care benefit
My opinion is that if a client has low income and few dollars to allocate to a qualified plan or revolutionary life, they should fund a tax-deferred 401(k) or IRA. This statement is enhanced if the client has a less than stable income. Why? To make life insurance work as a good wealth-building tool, it helps to fund a decent amount (at least $5,000 a year or more, and $10,000+ would be better); and it is vitally important to fund as budgeted for at least five years, and seven to 10 years would be better.
While I can make the numbers dance, that doesn't mean I should manipulate them to talk lower income/net worth clients into using cash-value life insurance as a replacement wealth-building tool for a 401(k) or IRA.
Asset allocation is the key. Clients should put some money in tax-deferred plans. Clients might want to buy real estate. Clients might want an after-tax brokerage account. But, many clients also should learn the real math and the virtues of a properly funded cash-value life insurance policy and also fund "X" amount of dollars into one as a safe, tax-favorable wealth building tool that can be used among other tools in retirement.
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