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According to the Investment Company Institute, “As of September 30, 2018, 401(k) plans held an estimated $5.6 trillion in assets.”
A substantial portion of those assets should be in a Split Funded 401(k).
Strategy for a Split Funded 401(k)
- Take maximum advantage of an Employer’s matching contribution.
- Redirect the after tax cost of the balance of the contribution to a cash value life insurance policy — my favorite is Indexed Universal Life (IUL).
- Compare the projected results with retaining the contribution to the 401(k) in excess of the employer’s match.
Case Study of a Split Funded 401(k)
Tom Graves, age 35, plans to take advantage of the $19,000 maximum contribution to his 401(k) effective January 1, 2019. His employer matches the first $4,000. Can an effective case be made for diverting the after tax cost of the remaining $15,000 beyond the employer’s match into a personal, non-deductible, retirement plan?
In Tom’s 30% marginal tax bracket, the after tax cost of putting that last $15,000 into his 401(k) plan is $10,500.
Let’s see what his retirement cash could look like if that $15,000 increases by 3.00% yearly representing potential increases to 401(k) contribution limits. We’ll compare that to the retirement cash flow generated by contributing that same $10,500 (increasing annually by 3.00%) to an increasing death benefit Indexed Universal Life (IUL) policy with an initial face amount of $513,647.
See the results in the graphic below.
| Image 1 |
| IUL vs. 401(k) |
| (Comparison of Benefits) |
It is difficult for some consumers to accept that such differences can really occur in favor of the IUL. Here are the reasons that favor IUL:
- Cash values securing loans participate in the selected index;
- Retirement cash flow via policy loans is free of income tax;
- Policy death benefits are free of income tax including any cash value component whether policy loans exist or not;1
- Overall plan costs (fees, taxes, mortality charges) are lower with IUL than alternative investments (see the graphic below).
| 1 | IRC Section 101 provides that the proceeds of life insurance maturing as a death claim are exempt from federal income tax. This means that if the policy is retained until death, any gain in gross policy values in excess of premiums paid remains tax free. |
Below is a graphic comparing the difference in overall Plan Costs between the 401(k) and the IUL.
| Image 2 |
| IUL vs. 401(k) |
| (Comparison of Plan Costs) |
| * | The Comparison of Plan Costs graphic above compares the management fees (1.00%) and income taxes (30%) on retirement withdrawals from the 401(k) to the mortality charges and policy expenses associated with the life insurance policy. (There is no income tax on loans from the IUL.) Even though the costs of the IUL continue to accrue after the 401(k) values expire in year 41 (age 75), the overall costs associated with the IUL at age 95 (year 60) are only 45.83% of the expired 401(k). |
Click here to view the full illustration with contributions, premiums and benefits. On Pages 6 and 7, you can see the year-by-year costs associated with each plan. (Note my margin comments on Page 6 of the illustrations.)
Alternative Investments
Have we provided this client with sufficient data for an informed decision? Perhaps not. What other factors should be considered? Let’s add two more alternative investments along with the 401(k):
- 401(k): 6.85% Yield (1.00 mgt. fee)
- Tax Deferred Account (like an indexed annuity): 6.85% Yield
- Equity Account: 6.85% Growth; 2.00% Dividend (1.00 mgt. fee)
Click here for comments on “Yields and Sequence of Returns”.
See below for a graphic that compares the IUL with these three alternatives, each one funded with $10,500 indexed at 3.00%.
| Image 3 |
| Various Financial Alternatives |
| (Comparison of Benefits) |
See below for a graphic of the difference in costs associated with the IUL, 401(k), Tax Deferred Account, and Equity Account.
| Image 4 |
| Various Financial Alternatives |
| (Comparison of Plan Costs) |
Click here to view the entire illustration.
Term Insurance
It is inevitable that term insurance will surface from folks like Dave Ramsey and Suze Orman as well as the occasional attorney and CPA (and most stockbrokers).
“Why go to all this fuss? Just keep the 401(k) and buy some cheap term insurance.”
OK, let’s see how much this bad advice costs this client.
I searched the web to find the lowest cost for $500,000 of 30-year, level term and found an annual rate of $435 for a male, age 35. So let’s analyze term insurance in combination with the 401(k). In this case, we will reduce the $15,000 (indexed) funding of the 401(k) each year by the $435 term cost so we have an even comparison.
| Image 5 |
| IUL vs. Term and 401(k) |
| (Comparison of Benefits) |
Click here for the full comparison report.
Conclusion
|
Every client with a 401(k) contribution in excess of the company match should consider a Split Funded 401(k).
Anyone with an IRA, Keogh, or 403(b) plan is also a candidate for a split funded alternative – and so are employer-paid, profit sharing plans. Note: Contributions to a 401(k), IRA, Keogh, 403(b), or profit sharing plan can be reduced or eliminated during times of financial stress – and restarted later. The same is true of most variations of 21st century, cash value life insurance – including IUL. |
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Video Analysis of the Comparison of Plan Costs
Click here for an 11-minute video refresher for the specifics of the InsMark Comparison of Plan Costs including details of the data input procedure. (It is the same for all three comparison modules in the InsMark Illustration System.)
Coming Attraction
In my next Blog #186, I’ll examine a Solo 401(k) for a dentist, age 50, with a contribution of $62,000, the 2019 limit for those age 50 and older.
Licensing InsMark Systems
To license the InsMark Illustration System, visit us online or contact Julie Nayeri at julien@insmark.com or 888-InsMark (467-6275). Institutional inquiries should be directed to David Grant, Senior Vice President — Sales, at dag@insmark.com or (925) 543-0513.
Creating Similar Presentations
If you would like some help creating customized versions of the presentations in this Blog for your clients, watch the video below on how to download and use InsMark’s Digital Workbook Files (or contact our Referral Resource in the section that follows).
Files For This Blog
New Zip File Downloaders
Watch the video.
Digital Workbook Files For This Blog
Experienced Zip File Downloaders Download the zip file, open it, and double click the Workbook file name to open it in your InsMark System.
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Before downloading and reviewing any files, be certain you have installed the most current updates to your InsMark System(s). Do this using Live Update available under Help on the main menu bar of the System or this icon on the main menu bar:
Note: If you are viewing this on a cell phone or tablet, the downloaded Workbook file won’t launch in your InsMark Systems. Please forward the Workbook where you can launch it on your PC where your InsMark System(s) are installed. |
If you obtain the digital workbook for Blog #185, click here for a guide to its content. It will be invaluable to you.
InsMark’s Referral Resources
(Put our Illustration Experts to Work for Your Practice)
We created Referral Resources to deliver a “do-it-for-me” illustration service in a way that makes sense for your practice. You can utilize your choice of insurance company, there is no commission split, and you don’t have to change any current relationships. They are very familiar with running InsMark software.
Please mention my name when you talk to a Referral Resource as they have promised to take special care of my readers. My only request is this: if a Referral Resource helps you get the sale, place at least that case through them; otherwise, you will be taking unfair advantage of their generous offer to InsMark licensees.
Save time and get results with any InsMark illustration. Contact:
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Important Note #1: The hypothetical values associated with this Blog assume the nonguaranteed values shown continue in all years. This is not likely, and actual results may be more or less favorable. Life insurance illustrations are not valid unless accompanied by a basic illustration from the issuing life insurance company.
Important Note #2: The information in this Blog is for educational purposes only. In all cases, the approval of a client’s legal and tax advisers must be secured regarding the implementation or modification of any planning technique as well as the applicability and consequences of new cases, rulings, or legislation upon existing or impending plans.
Important Note #3: Many of you are rightly concerned about the potential tax bomb in life insurance that can accidentally be triggered by a careless policyowner when policy loans are present and net cash values are so low that the income tax on the gain on surrender (calculated using gross cash values less basis) is more – often significantly more – than the net cash surrender value.
This lurking tax bomb can be present in all forms of whole life and universal life where policy loans of any type are utilized. It can be avoided, and you, the producer, are key to making sure your clients are aware of how to sidestep it.
A tax bomb can be avoided if the policy is neither surrendered nor allowed to lapse, since the policy death benefit wipes away the income tax liability. The foundation of this special treatment is IRC Section 101. This statute provides that the proceeds of life insurance maturing as a death claim are exempt from federal income tax. This applies to the full death benefit, including any cash value component whether loans exist or not.
Can your clients remember these facts years into the future? If they are incapacitated, will family members understand the issues? It is probably best to file a short note with the policy – something like this (although your compliance officer will likely have preferred language):
If/when you take policy loans on this policy, be sure to talk to your financial adviser before surrendering or lapsing the policy in order to anticipate unexpected tax consequences that may otherwise be avoided.
Does this note make it harder or easier to deliver the policy? It’s harder if you haven’t discussed it with your client; easier if you have. And that’s the point – you should discuss it.
Some life insurance companies have concierge units that monitor loan status at the point of lapse or surrender, and you would be well-advised to select an insurance company with this capacity. To be effective regarding the tax bomb, such carriers need to be proactive in their client relationships, not merely reactive to client inquiries. I hope that ultimately the policyholder service division of all life insurance companies will bring this potential liability to the attention of those surrendering or lapsing policies, particularly those policies with 50% or more of the gross cash value subject to outstanding loans.
More Recent Blogs:
Blog #184: Knock Your Socks Off (Part 2)
Blog #183: Are Your Clients Too Old to Use IUL in a Retirement Plan?
Blog #182: Endorsement Split Dollar with Salary Continuation at Retirement
Blog #181: Endorsement Split Dollar with Optional Transfer
Blog #180: A New Look at Various Financial Alternatives (It Will Knock Your Socks Off)
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