The following is from my book the Home Equity Management Guidebook: How to Achieve Maximum Wealth with Maximum Security. Click here to learn more about the book.
It should explain the how I run apples to apples comparisons in the book and in my recent newsletters. If you have any questions, please e-mail firstname.lastname@example.org.
Funding Qualified Retirement Plans and/or Post-Tax Brokerage Accounts vs. Cash Value Life Insurance
To date there has been no “authoritative” writing with real detail on two questions which are raised over and over in the life insurance and financial planning communities.
Question 1: Is it better for you to fund a qualified retirement plan such as a 401(k) plan or Roth 401(k) plan; or, is it better to take your income home, pay tax on it, and fund cash value life insurance as a retirement vehicle?
In this chapter, I will show you with real-world math using different variables how much you can anticipate receiving after tax in retirement from Roth or traditional 401(k) plans vs. after tax from a cash value life insurance policy.
Question 2: Is it better to fund a post-tax brokerage account to grow your wealth or use cash value life insurance? Again, I will show you with real-world math how much you can anticipate receiving after-tax in retirement from a brokerage account vs. after-tax from a cash value life insurance policy.
LAYOUT OF THIS CHAPTER
This is not going to be the easiest chapter of a book you’ve ever read. I usually have a good knack for breaking down complex topics into English for people, and this chapter will challenge that ability. Actually, the subject matter of this chapter is not too bad; but because of the multiple comparisons and charts and graphs, it will probably be a bit confusing for some readers.
The good news is that the details that support the conclusions are in this chapter, but I also have summaries with just the conclusions. Therefore, you can read as much as you want and read it over a few times to get all the details; or you can take the conclusions as they are. I recommend learning the details that support the numbers; but, the bottom line is that I want you to know the outcome of the math, which will be very interesting and eye opening for most readers.
The chapter will be laid out as follows when dealing with a particular client (Mr. Smith) who is looking to build wealth for retirement.
This material will:
1) Illustrate how much after-tax retirement income Mr. Smith will have available using a Roth 401(k) plan.
2) Illustrate how much after-tax retirement income Mr. Smith will have available using a traditional/deductible 401(k) plan.
3) Compare what Mr. Smith has available from a Roth and traditional 401(k) plan to what he could receive if he funded a cash value life insurance policy.
4) Illustrate how much after-tax retirement income Mr. Smith will have available when funding a typical after-tax brokerage account.
5) Compare what Mr. Smith has available from the post-tax brokerage account to what he could receive if he funded a cash value life insurance policy.
Why Roth plans first?
Because as the numbers indicated in the chapter on Traditional Wealth Building, Roth plans, for the vast majority of clients, are a better way to build wealth than traditional tax- deferred IRAs or 401(k) plans.
The maximum contribution amount to a Roth 401(k) plan as a salary deduction in 2008 is $16,000. For easier math, I will use $15,000 as the annual contribution as the baseline for all the examples in this chapter.
The material to follow will illustrate the economics of a Roth 401(k) plan for a client who is in the 40%, 30%, and 15% income tax brackets, both when contributing to a Roth 401(k) plan, and when removing money from a Roth income-tax free in retirement.
For the examples in this chapter, assume the client, Mr. Smith, who is age 45, contributes $15,000 to a Roth 401(k) plan each year for 20 years and takes distributions from the plan from ages 66-85.
Because the contribution is non-deductible to the Roth 401(k) plan, he will have to pay the following taxes on his contribution to a Roth. The amount of tax depends on his income tax bracket. As stated, I will show you numbers for each tax bracket so you can look at the one that most closely fits your situation:
- 40% tax bracket = $6,000 tax
- 30% tax bracket = $4,500 tax
- 15% tax bracket = $2,250 tax
The examples in this chapter all assume a fairly conservative 7% investment return over the life of plan.
For a comparison example using a traditional 401(k) plan, Mr. Smith will invest an amount of money equal to the taxes he would have saved had a "regular" non-Roth 401(k) plan been implemented (a side account).
In other words, if Mr. Smith funded a traditional tax deductible 401(k) plan, he would NOT have had to pay the taxes listed above when funding a non-deductible Roth 401(k) plan.
Therefore, when comparing numbers for Mr. Smith to fund a Roth 401(k) plan, he would have to fund into the side fund $6,000 in the 40% tax bracket, $4,500 in the 30% tax bracket, and $2,250 in the 15% tax bracket.
When most advisors discuss a side fund, they are talking about a typical investment account. When clients actively invest money in the stock market (after-tax), in order to have a “real- world” example, the numbers must reflect capital gains/dividend taxes on the post-tax brokerage account. The following are the assumed annual taxes on the growth in the actively managed side account:
- 25% for a client in the 40% tax bracket
- 20% for a client in the 30% tax bracket
- 15% for a client in the 15% tax bracket
Alright, now that you have an understanding of some of the variables (and if you don’t, don’t worry, I’ll give you the charts which show you the answers), let’s see how Mr. Smith does with retirement planning using these various plans.