The 401(k) Versus the IUL (Part One)
Which One Is Better For Building a Retirement Income?
Advantages and Disadvantages of the 401(k)
I have noticed that the most popular article on this site is a comparison between the 401(k) and an Indexed Universal Life policy (IUL), which I wrote almost two years ago. So, I’ve decided to re-visit this subject in a more complete way (in two parts). I hope you find this useful and will offer your comments at the bottom.
I am a licensed life insurance agent. I don’t sell securities, I’ve never worked in a Human Resources (HR) Department, and I admit I’m not an unbiased judge. But if there are any errors in the paragraphs that follow, I hope you’ll point them out.
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Advantages of a 401(k)
The 401(k) is a retirement savings program sponsored by many businesses, which offer this program instead of a classic pension program. Here are the reasons you might want to use a 401(k) to save money for retirement –
1. The 401(k) features an automatic payroll deduction so you don’t have to fight with yourself about whether to save the money or spend it. You may contribute up to 15% of your pay, up to a limit of $17,500 unless you’re over 50 years old, in which case you may contribute an extra $5,500 per year.
2. Many employers offer “matching” funds, where the employer matches your deposits up to a certain level each year, say 4-10% of your pay.
3. You get a tax deduction for the year in which the money is deposited into your account (the payroll deduction, not the matching funds), reducing your income taxes for that year.
4. You’re given a choice of investment options provided by your employer, most often a selection of mutual funds that invest in different segments of the market and allow you to tailor your investment to the level of risk which you are willing to accept.
5. Finally, when the stock market goes up, the account grows tax deferred until retirement.
Please let me know if I missed any of the advantages. In theory, the 401(k) offers a way to force you to save money, tax-deferred, for the future. But there are problems with this program.
Disadvantages of a 401(k)
The main problems of the 401(k) programs involve a lack of access, lack of control, risk, expenses, and the building of a future income tax problem. Let’s look at these –
1. Once money has been deposited into your 401(k) account, it is difficult and/or expensive to spend this money prior to age 59 ½. Most early withdrawals will be subject to a 10% penalty and will also be taxed as regular income. There are some exceptions, but they are strictly limited (if you’re a first time home buyer or have certain hardships like medical expenses, funeral expenses, job termination after age 55, or if you become disabled are examples). It is possible to borrow money from your 401(k) (at 5% currently), but the money must be paid back with interest within five years or it will be treated as an early withdrawal. If you are fired or laid-off before all payments have been made, the outstanding amount will be treated as an early withdrawal. In addition, any money borrowed stops earning interest that would have contributed to the growth of the account. There is also the “72(t)” option, where you may be allowed to take regular withdrawals over a period of time. However, these withdrawals must continue for at least five years and you may not add money to your account during these years, which will seriously limit the amount of growth over time and greatly reduces the income you will have in retirement..
2. Once you begin contributing to a 401(k), you may be able to increase or decrease the percentage of your income being deducted, but you cannot change the maximum limits allowed. You have no control over the amount of matching provided by your employer; who may increase the amount, decrease it, or do away with it entirely. You normally cannot choose to close the account and move it without quitting your job. If you don’t like the investment options provided by your employer, you cannot change them. If you want to start taking regular withdrawals before age 59 ½, you cannot do so without paying taxes and penalties. If you don’t need to take withdrawals at age 70 ½, the government will force you to do so (so they can start collecting all the deferred taxes) by charging you taxes and penalties on the money you didn’t withdraw.
3. Money will be invested in the stock market. When the market is going up, this is a good thing. But when the market is going down, your savings can be wiped out. This is not just a theoretical problem. Many people who retired near or soon after the market crash of 2008 found that their retirement dreams had been shattered by market losses. While the market came back in late 2012 and 2013, many of the people wiped out in the market crash were no longer IN the market and, thus, did not share in the gains. The fallout from the last market crash includes the facts that many seniors have been forced to continue working long after age 65, or they have had to dramatically scale back their retirement plans. Did you know that the largest employers of seniors in the U.S. are Walmart, McDonalds, and Burger King? Is that how you want to spend your retirement years?
4. The expenses charged against 401(k) accounts have been a secret that the securities industry did not want leaked. (there is a video from the “60 Minutes” tv show on this website that talks about these expenses, view it HERE) But in 2012, it became a legal requirement for certain expenses to be reported on the annual reports that show how your 401(k) is doing. These are just the charges by the company managing the 401(k), however, and do not include charges rung up by the mutual funds when they buy and sell stocks. Very few people are aware of all the charges and expenses that are reducing the amount their account grows each year.
5. Because the money deposited in a 401(k) gets a tax deduction when it is deposited and grows tax-deferred, all withdrawals become fully taxable as ordinary income at the time of withdrawal. Many people do not realize that the amount of taxes they saved when building their account will be paid back in just a few years, with all money withdrawn after that being assessed NEW taxes.
Here’s an example – Let’s say you earn $100,000 per year and deposit 15% of your income ($15,000) each year. That’s roughly $5,000 a year in tax savings (if you have kids and a mortgage, your tax savings are actually much less). If you were 35 when you started your account and saved for 30 years at this rate, you would have saved $150,000 in taxes and your account value has grown to, maybe, $1,200,000 by age 65 (a 6% annual growth rate). They used to tell retirees they can safely withdraw 4% of their savings per year but many advisors now know that that is too aggressive because we are living a lot longer than we used to be. If you withdraw 3% per year, that’s an income of $36,000 a year. This income is all taxable and, odds are, the kids have left home and the mortgage has either been paid off or paid down, so your deductions are much lower than they used to be.
In addition, your income will be high enough that part of your social security income will now be taxable (currently, if filing an individual return, additional income between $25k and $34k causes 50% of Social Security income to be taxable; over $34K causes 85% to be taxable. The rules for joint returns are – income between $32k and 44K are 50% taxable, with joint income over $44k 85% taxable). If you earned $100k per year, you’re going to earn the max Social Security income of $2,533 (currently), bringing your total income (not including your spouse’s Social Security income) to over $66,000. If you only have to pay 25% taxes on your $36,000 income plus ½ your social Security income ($15k), you’re paying $12,750 a year, paying back your $150,000 in tax savings in less than 12 years.
If you had more tax deductions while working, your tax savings from the 401(k) deposits will be less and you’ll pay back the savings sooner. If you earn better than a rate of 6% on your 401(k) savings, your taxes will be higher and will pay back the savings sooner. If your employer offered matching money, your account growth and retirement income will be higher, and you will return the tax savings sooner. If your spouse has retirement or Social Security income, your taxes will be higher and you’ll pay back the savings sooner.
The bottom line here is – the tax deduction you get when depositing money into a 401(k) is overrated and assumes that your tax rate will be lower in retirement than it is when working full-time. Overall, tax rates are at historically low levels currently and the U.S. has accumulated a MASSIVE debt burden. Do you really think tax rates will be LOWER when you retire? And please note: when you die (regardless of age), your heirs will get the balance in your account and all of the money will be taxed to them as regular income that year.
Is there a better way to save for retirement? I Believe there is. In Part two of this series, we’ll examine the Advantages and Disadvantages of an IUL.
Life Insurance Agent, Santa Clarita, California
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