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 episode of Money Script Monday, Brian takes on the hotly debated topic of whether to save for retirement through a 401(k) or an indexed universal life policy.

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Video transcription

Welcome to another episode of "Money Script Monday." My name is Brain Manderscheid. Today, I want to answer the question, "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 high income earners.

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 at a shock to many retirees who may actually find themselves in a higher tax position were than their working years.

The reason being is the IRS actually requires you to take minimum distribution starting age 70.5 on any tax-qualified account like let's say a 401(k), IRA, etc.

Additionally, if we take a look at this graph there's a Bell Curve effect on our account value of our 401(k) as well.

Starting the 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%.

Let's say, hypothetically, you're earning 7% rate of return, you have to withdraw roughly at half of that, 3.65%, you're not going to experience a lot of growth in your portfolio beginning off.

Once we get to age 87, as you age the divisor reduces which increases your withdrawal rate.

And at age 87 the withdrawal rate is actually 7%.

So again, that same scenario, a 7% rate of return with a 7% withdrawal in this scenario, now, we have a flattening effect on our 401(k).

As we age past age 87 at 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 distributions that the IRS requires, there's actually up to a 50% penalty for not doing so.

If we look at this shade of selection from 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, 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?

Over that timeframe, age 75 to 95, is likely when most people are going to pass away with a life expectancy of let's say age 87 or a little before that.

With our 10% peak income value, your kids are likely to be within the age range of let's say 55 to 65. Over that period of time, they're likely in their highest income earning years of their life, so during the working years they may be at a 24% tax rate.

If you pass away and transfer this large 401(k) balance to your kids, that may actually bump them up into the highest marginal tax rate of 37%.

We talked about the IRS required distributions, let's talk about the tax selections that the IRS allows us to choose.

Tax selections

Of these three dollar amounts, $5, $10, and $20, the IRS actually allows us to choose to pay taxes on one of these dollar amounts.

If I were to ask you, or 100 people, 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 allows us to pay taxes on one of these three amounts. You could choose to pay your taxes on the $5, let your money accumulate tax-free and transfer and distribute tax-free.

That my friends would be two vehicles that allows you to do that.

Roth IRA

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 and tax-diversify your portfolio.

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.

Considerations

The number one problem facing retirees are adverse stock market corrections.

Many investors remember what happened in 2008, what happened in the beginning of the 2000s of the 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 nine-and-a-half-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, live to age 86, 21 years you're likely to have three stock market corrections over that timeframe, 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 equity index up to a cap or a limiting factor, but the trade-off is as your percent annual floor.

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 for your 401(k) or an IUL, what I would say is it makes sense to tax-diversify your portfolio.

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, we should also tax-diversify our portfolio to hedge against future tax rate increases.

The likelihood is we're likely to experience tax rate volatility over our lifetime.

New 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.

With that folks, thank you very much for tuning in today. We'll see you next time.