There seems to be a few crucial yet seemingly unanswered questions in the financial planning community these days:
1) Whole life vs. Indexed UL: Which policy will generate more cash value?
2) Which equity indexed life insurance (EIUL) policy will provide the most retirement income for your clients?
3) Is it a good idea to income tax-defer money into a qualified retirement plan or IRA?
This article will focus on the question No. 3; I will deal with Roth IRAs and Roth 401(k) plans in a separate article.
Why income-tax-defer into a 401(k) or IRA?
When you income-tax-defer money, you are using the government's money for a period of time to help increase your retirement nest egg. If you have clients in the 35-percent tax bracket and asked them if they would like to put $1 to work in a tax-deferred account or 65 cents after-tax, which would they chose? Of course, they would choose the $1 option. So, what's the problem with income-tax-deferring money? You have to pay income taxes on all of the money when you remove it from a tax-deferred account.
Let's look at an example. Assume you have a 45-year-old client in the 35-percent income tax bracket who can tax-defer $15,000 each year for 21 years into a 401(k) plan. Assume the money grew annually at 7 percent (gross) in mutual funds with a 1.2 percent annual mutual fund fee. Assume the client removed the money from the retirement plan in equal amounts from ages 66-85 where the account balance is zero after the last withdrawal.
How much would the client have, after-tax, each year in retirement if we assume he is in the 35-percent income tax bracket in retirement? The answer is $29,642 (his gross withdrawals are $45,604 a year).
Most people think our income- tax brackets are going to be changing with the new president. Consider some of the highest personal income-tax brackets in the past:
- 1965: 70 percent
- 1980: 70 percent
- 1986: 50 percent
It's safe to say that we are at historic lows when it comes to our personal income-tax brackets (and it's not going to last much longer).
What if we assume the example client will be in an even higher tax bracket in retirement? The question then becomes how high will the income tax be in five, 10, 15 to 20+ years? The answer is that no one knows. Therefore, I've just created a chart of how much money would be left after taxes upon the withdrawal given in the previous example based on multiple tax brackets.
|Income tax bracket in retirement||Annual amount withdrawn|
|70 percent||$13,681 |
*If you lived in California, you'd pay an additional 9.3 percent in personal income taxes on withdrawals.
What's the point? Simply telling someone to income- tax-defer money into a qualified retirement plan or IRA is not as simple as it sounds. You need to discuss with your clients whether it makes sense to fund them; and, if not, what other alternatives are available.
Stock market protection
Aside from the potentially disastrous tax implications of funding qualified plans, due to the vast majority of clients putting their 401(k)/IRA money into mutual funds, they have no stock market protection. How's that working out for most of the American public over the last 18+ months? Not too well.
Assume you have a client who had accumulated $250,000 in a tax-deferred 401(k) plan by October of 2007 and is getting close to retirement. What was the account balance in October of 2008 after the market declined by approximately 46 percent? $135,000.
Again, I'll ask the question: Is building wealth using income-tax-deferred 401(k) plans/IRAs a good idea? The answer is that it almost always makes sense to fund a 401(k) plan if an employer will match the employee's contribution.
But what if the example client took his money home (instead of tax-deferring it into a qualified plan), paid taxes on it in the 35-percent bracket, and invested into mutual funds with a 1.2 percent annual expense and a 20-percent blended capital gains/dividend tax rate on the gains? How much could be removed from that account every year from ages 66-85? $26,032.
How much could the client receive from his 401(k) plan after taxes? $29,642.
Hmm... that's odd. Why then does this article indicate that it is not a good idea to fund a tax-deferred qualified plan? Because there are other alternative places a client can grow wealth and receive:
- More after-tax money in retirement
- Protection from stock market risks
- Protection for the family if the breadwinner dies early
- A free long term care benefit
What wealth-building tool has the above characteristics? Revolutionary life insurance. Read Part 2 of this series to find out more.
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