The 401(k) has become the standard-bearer for retirement savings accounts. While many people enjoy the immediate tax deferral benefit, they often times do not think of the significant tax liability they could incur later on in their life. An indexed universal life (IUL) policy has been making waves in the financial industry due to its three tax benefits that no other financial vehicle can offer: (1) tax-deferred growth, (2) tax-free distribution, and (3) tax-free wealth transfer. Yet many still defer back to the 401(k) option.
In this blog, Mel takes on the hotly debated topic of whether to save for retirement through a 401(k) or an indexed universal life policy.
“Where should you put your money, your 401(k) or an IUL?”
To answer that question I would say it really depends on your individual situation, which is why it’s important to work with a qualified advisor.
However, if you’re already maxing out your 401(k) or your employer match of your 401(k) and looking for an additional tax-advantaged place to put your money the IUL might be the right vehicle.
What I want to talk about today is a widely available yet rarely discussed retirement strategy specifically designed for families who wish to enhance their future retirement.
To do that, I want to talk about the IRS required distributions, the tax selections that the IRS allows us to choose, as well as some additional considerations.
IRS required distributions
So first, let’s talk about the IRS required distributions. This actually comes as a shock to many retirees who may actually find themselves in a higher tax bracket in retirement than they were in their working years.
The reason for this is the IRS actually requires you to take a minimum distribution starting age 70.5 on any tax-qualified account such as a 401(k), IRA, 403-B, SEP IRA, 457 plan of a simple IRA.
Take a look at this graph above there is a Bell Curve effect on your account value of our 401(k) as well.
Starting at age 70.5 based on the IRS Publication 590, the Uniform Distribution Table, there is a divisor of 27.4%.
What that equates to at age 70.5 is a withdrawal rate of roughly 3.65% using a $100,000 IRA, for this example.
Let’s say, hypothetically, you’re earning 7% rate of return, you have to withdraw roughly half of that, 3.65%, you’re not going to experience a lot of growth in your portfolio with this much of a withdrawal.
Once we get to age 87, the divisor reduces, however your funds have decreased which increases your withdrawal rate.
So at age 87 the withdrawal rate is actually close to 7%.
That scenario we discussed above, you are earning a 7% rate of return on your qualified account but based on your age you are required to withdraw 7%. The outcome of this is a flattening effect on our 401(k).
As we age, between age 87 to age 90, there’s actually a 10.5% withdrawal rate.
So not only are we taking all the gains, we’re actually starting to eat into principle, which is why you can see this falling off effect in the latter years of life.
If you don’t take your required minimum distributions that the IRS requires, there’s actually a 50% penalty on the required distribution that you should have taken plus you still owe the tax on the required distribution.
If we look at the graph between ages 75 to 95, your 401(k) balance will actually be within 10% of your peak value during that 20-year timeframe.
Regardless of the rate of return you earn during your retirement years, and because of the increasing withdrawal rate, your 401(k) will never properly grow and accumulate like you may have expected.
Additionally, what happens when your 401(k) is transferred to the next generation?
Most individuals life expectancy is between the age of 75 to 95, this means your children will inherit this money in the age range of let’s say 55 to 65.
During that period of time, they’re likely to be in their highest income earning years of their life, if they are in a 24% tax bracket at that time of their life and they inherit a large 401-k, that has the potential of bumping them into the highest marginal tax rate of 37%.
Hopefully this gives you an idea of what you are facing regarding retirement accounts and the potential taxes that will be due.
Let’s change our discussion and discuss the tax selections that the IRS allows us to choose.
If I were to ask you which would you rather pay taxes on, 99% of people are going to say that $5 amount because it’s smaller they’re going to pay lower taxes.
Believe it or not, most people do the exact opposite with their 401(k) or IRA.
They decide to take the tax deferral or tax postponement, accumulate the money tax-free or tax-deferred and then pay taxes on the distribution and transfer.
In doing so, they may actually be paying much more taxes over their lifetime and also be subject to higher tax rates down the road when they retire.
Again, I mention that the IRS gives us the choice, upfront, to pay taxes on one of these three amounts. You could choose to pay your taxes on the $5, this lets your money accumulate tax-free and transfer and distribute tax-free.
There are two financial vehicles that allows you to do that.
One would be a Roth IRA.
Now, if you make $199,000 of income of modified adjusted gross income or greater, the IRS actually bans you from contributing to a Roth IRA.
Additionally, if you make under that limit or any amount for that matter, the max contribution you could make to a Roth IRA is $5,500 or with a catch-up provision starting at age 50 $6,500.
That’s not a lot of money to contribute to a tax-free vehicle.
Cash Value Life Insurance (Indexed Universal Life)
If you can’t contribute to a Roth IRA or want to contribute more than what the IRS allows you to do for the Roth IRA, the only other option you have is cash value life insurance, which we generally use Indexed Universal Life (IUL) for our preferred vehicle.
We talked about the IRS required distributions. We talked about the tax selections that the IRS allows to choose one. Now let’s talk about some additional considerations.
The number one problem facing retirees are adverse stock market corrections.
Many investors remember what happened in 2008, do you remember what happened in the beginning of 2000? A 40% plus decline in our portfolio value.
Hypothetically, if you retire and it so happens you retire during a bear market when the stock market drops, that has a significant impact on the longevity of your 401(k) or your traditional retirement accounts.
That is called a sequence of returns risk.
If we were to look at the U.S. stock history over its course and examine how many corrections on average that we have, we generally have one correction every seven years.
Currently, we’re actually in a 10-year bull market, which is the longest on record.
Many people always ask, “When is this bull market going to end?”
That’s actually not the right question.
The right question is not if, not when, but how many times we have a stock market correction over the course of your retirement years.
Let’s say you retire at 65 and live to age 86, that?s 21 years, you’re likely to have three stock market corrections over that time frame, which could significantly impact your ability to safely retire.
Other than the tax benefits of the IUL, the second greatest benefit is the ability for the IUL to guarantee your cash value against these adverse stock market corrections.
The way the IUL works, it allows you to participate in the upside of an market index, such as the S&P 500, capping your growth between 10% to 15%. Here is the best part, if the markets decline, you do not participate your money just doesn?t grow that year.
So, if the stock market goes down 40% like it did in 2008, you would actually receive 0% and not lose any of your principle due to those adverse stock market corrections.
To wrap things up, today we talked about the IRS required distributions, one of the problems facing 401(k)s, we talked about the tax selections that the IRS allows us to choose one, and we talked about some additional considerations regarding the stock market.
To go back to the question where should you put your money. A qualified account such as a 401(k) or an IUL? ?What I believe is it makes sense to tax-diversify your portfolio. You should have both.
Just like modern portfolio theory, which basically says we should allocate a portion of our money to equities for growth, a portion of our money to fixed income for stability like bonds. Cash value life insurance, and annuities, also tax-diversify your portfolio to hedge against future tax rate increases.
The likelihood is we’re likely to experience tax rate volatility over our lifetime.
New government administrations will come in and change what we today call permanent tax laws, either upwards or downwards.
Having money in both taxable, tax-deferred, and tax-free positions allows us to better hedge against tax rate volatility over both our working years and our retirement years.
So, the answer doesn’t have to be 401(k) or IUL.
These two vehicles actually work together in unison and in harmony to allow us to hedge against tax rate volatility, the upwards and downwards climb of tax rates over both your working years and your retirement years.
Thanks for reading my blog. If you wish to look at ?Cash Value Life Insurance? and see how it could benefit you and your family please call me at 888-839-3536.