by Michael Goodman
The 400% Solution:
This may be the most important post I’ve added to this website. If you are making regular deposits in a “qualified” retirement program – a 401k, a 403b, 457, TSA, or traditional IRA – and IF the purpose of these deposits is to build a retirement income, then you MUST read this carefully.
The following comparisons will show the amount of after-tax retirement income you can expect to build by making deposits to a qualified retirement plan from different ages, then we’ll compare that income to the tax-free distributions you might get from an IUL (indexed universal life insurance) policy.
In each example, we’ll assume the qualified plan will earn 8.39% interest from start through age 90 (8.39% is the 30-year average of the S&P 500 index), even though few people actually earn that high a rate in their qualified plans (the mutual and money-market funds typically offered in qualified plans also do not average that much over long stretches).
We are also NOT assuming any matching funds because the trend for this is downward, and every company has its own policy on whether to add matching funds or not. The IUL will also assume that the performance of the S&P 500 will continue as it has for the last 30 years, but will have a floor of 0% in any year and a cap rate of 14.5%. However, NONE of the examples given are guaranteed.
The 25 Year Old
If you start a 401k or other qualified plan at age 25, depositing $200 a month through age 65, you’ll have $782,113. If you assume the same rate of interest through retirement as you had during the growth years (8.39%), and expect to die by age 90, you can withdraw $74,783 a year assuming you are trying to hit $0 on the nose. HOWEVER, if your money earns less in retirement, or if you live longer than expected, you will run out of money too soon. ALL advisors will tell you that withdrawing 9.56% of your qualified money each year is too aggressive. For many years, it was believed that a 4% draw rate was a safe rate. But current research indicates that even that rate may be too aggressive, especially if you experience a market crash early in retirement. So, most advisors now recommend withdrawing just 3% per year (see article here).
If you withdraw 3% per year, the expected income becomes $23,463 per year, all taxable unless it’s from a Roth. If you’re just in the 15% federal tax bracket, this amount will be reduced to $19,944 per year. Keep in mind that most qualified plans will not average 8.39% growth for life and, if you have other income, you may be in a higher tax bracket; and either of these will reduce your after-tax income.
By comparison, if you put the same $200 a month into an IUL through age 65 and benefit from the exact same market performance, you can start taking tax-free distributions of $92,850 per year (if you are a woman; a man would receive a little less) for life, regardless of how long you live, PLUS your heirs will receive a tax-free death benefit when you die. This example also assumes that future performance of the S&P 500 will mirror the past performance, which probably won’t happen. If the S&P 500 does not perform as well, your distributions from the IUL will be lower; however, if the S&P 500 does better than it has, your distributions will be higher. But, if the market performs as projected, the tax-free distributions from the IUL will be 465% higher than the after-tax distributions from the qualified plan (396% higher than a Roth).
The 35 Year Old
If you start at age 35 and put the same $200 a month into a qualified plan to age 65, then begin distributions at age 66, your money should build to $323,765. 3% of this is $9,713 per year before taxes. If the tax rate is 15%, then you get $8,256 after taxes.
If the same money went into an IUL and the market performs as expected, a woman may be able to take distributions of $35,994 per year, tax-free. This is 436% higher than the qualified plan and 371% higher than a Roth.
The 45 Year Old
If you start at 45 and put the same money into a qualified plan through age 65, you should have $123,680. 3% of this is $3,710 per year before taxes, $3,154 after taxes at 15%.
The IUL for the 45 year old woman produces $13,273 per year, tax-free. This is 421% higher than the qualified plan and 358% higher than a Roth.
THE 55 YEAR OLD
The qualified plan for the 55 year old builds to $37,396. 3% is $1,122 per year, $954 after taxes.
The IUL produces $3,205 per year, tax-free. This is 336% higher than the qualified plan and 286% higher than a Roth.
At most ages, an IUL will produce significantly higher after-tax retirement distributions than if you put the same money into a qualified plan or a Roth. ALL options produce a lot less income if you don’t get started early! While all options are affected by the growth of the stock market, money in an IUL is guaranteed not to go down because of the market. Is your qualified plan protected from drops in the market?
There are many more caveats and qualifications that I go through with clients. If you have questions about any of this, please let me know.
4 thoughts on “The IUL (Indexed Universal Life) Versus Qualified Plans for Income”
Can you explain in detail on this scenario? I assume cash value will be less than 401K assuming the same rate because of COI and fee in IUL. Would you agree?
>> 25 YEAR OLD
By comparison, if you put the same $200 a month into an IUL through age 65, you can start taking tax-free distributions of $92,850 per year
Thank you for the question, Jay. The answer for this example is yes, the total cash value at age 65 will be higher IF you have no costs for the 401k. In the example I gave, I used a growth rate of 8.39% and costs of 0% per year. I don’t know any 401k’s that have zero costs though, do you? Even if the annual fees in the 401k are lower than the costs in the IUL, the IUL will normally produce higher after-tax retirement distributions because, 1, the COI in the IUL is based on the actual coverage and is not levied on the total cash value and, 2, the distributions from the IUL will be free of income taxes (usually). Here’s an example of what I’m talking about – if there is $500,000 in the 401k and the annual fees are 1% (a common number), that’s a fee of $5,000, right? That’s a lot more than the COI in an IUL with the same cash value because the COI depends on the amount of insurance, plus the age and health of the insured when they bought the policy. Even if the 401k is made up of nothing but index funds with an average fee of just .25%, how much is the annual fee? $1,250 a year, much higher than the COI for the IUL in most cases. And the annual fees for the 401k will go up every year that the cash value goes up (by the same percentage, right?). That is not the case with an IUL. The truth is that the higher the cash value in the 401k, the greater the advantage held by the IUL for costs and fees.
I agree with your analysis on 401k plan cost and mutual fund fee.
But I still can’t get the math right on “25 year old” example.
$200 monthly policy generates lifetime annual income of $92,850, from age 66 forever. Can you shed some light on how to achieve that with IUL? what is the rate of return on what face amount, etc.
The IUL example assumes a rate of 8.6% and deducts all COI, compared to the 8.39% growth for the 401k with no costs. During the 30 year period ending 2013, the S&P500 averaged 8.39% annual growth, but an IUL with a cap rate of 14.5% and a floor of zero averaged 8.6% over the same period. The distributions from the IUL are a higher percentage of the cash value because they are tax-free policy loans. Policy loans do not reduce the balance of the cash value and result in a higher continued growth rate while distributions are coming out. The same is not true of the balance in a 401k where distributions DO lower the cash balance. Keep in mind that policy loans in an IUL can carry an interest rate of 0%, and require no payments until you die. Technically, since the loans are repaid from the death benefit, you are taking an advance on the death benefit. This is why I say that this kind of policy is for people that want to spend a chunk of the death benefit while they are still alive.
So, a 401k invested in an Index Fund may have higher costs over the course of the account, distributions will be taxable, and the net after-tax distributions will probably be about 25% of the tax-free distributions from the IUL. HOWEVER, we are assuming future growth of the S&P 500 is similar to the past growth. There are numerous assumptions in my example and I really only nail things down when I meet with clients personally. Each IUL is a custom built product and there are several options that will influence the long-term performance.