Cure the mid-life crisis: Stop funding qualified plans
By Jeff Janes
Time to be honest here—mid-life comes around 40, maybe 45 at the latest. By the time you reach 50, you’re way past prime-time. Sure, I’d love to live to 100, but I don’t think that’s going to happen. Average life expectancy is 87 (by the way, we’re all pretty average). Considering that most financial professionals have saturated the baby boomer market, isn’t it about time we start looking at the next retirement catastrophe—those approaching their mid-life crisis?
As I hit middle age, I fondly remember when retirement seemed personally unattainable. Now, with each birthday, I wonder, “Am I adequately prepared for retirement?” Then, the government likes to spoil your birthday party, too. Have you ever read page two of your annual Social Security statement, right below “Your Estimated Benefits”? How’s this for a birthday spanking, as the bold-print disclaimer reads:
Your estimated benefits are based on current law. Congress has made changes to the law in the past and can do so at any time. The law governing benefit amounts may change because by 2041, the payroll taxes collected will be enough to pay only about 78 percent of scheduled benefits.
Today, not many people younger than age 40 are even counting on Social Security as a retirement income supplement. Many of your clients also face this frightening fact: With a perfect storm brewing, why would we even consider recommending stopping qualified plan funding? Well, through some recent product innovations, you can honestly recommend stopping qualified plan funding and provide your clients with a comfortable retirement, all while creating a stronger overall financial plan. It’s quite simple, really.
Why stop funding qualified plans?
According to the 2008 Retirement Confidence Survey, 47 percent of workers say they have tried to calculate how much money they will need for a comfortable retirement. In addition, the percentage of workers confident about having enough money to enjoy a comfortable retirement sits at a lowly 18 percent. With so few Americans adequately prepared, and most worried; again, why would we even suggest stopping qualified plan funding? It comes down to flawed assumptions and inefficient vehicles.
First, for a qualified plan to work efficiently, the theory goes that you defer taxes during your peak working years and then consume the money and pay taxes in retirement—where hopefully you will be in a lower tax bracket. That’s a great theory, but with the massive explosion of baby boomers now moving through the system and starting to rely on and use government programs, where will the money come from to fund those benefits and taxes?
I don’t know a single person who’s age 45 or younger who really believes their tax rates will be lower when they retire. Throughout the past century, the U.S. marginal tax rate ranged from below 10 percent to more than 90 percent. Today, the marginal tax rate hovers at around 35 percent. And, almost every economic expert agrees that tax rates will most likely be higher—perhaps significantly—one or two decades from now.
Second, the U.S. Department of Labor shows that a worker between the ages of 18 and 38 changes jobs an average of 10 times. With frequent job switching going on, most individuals younger than age 45 probably left behind a few 401(k) plans along the way—orphaned and not rolled over to the new employer. Client portability should have a strong appeal, as well as consolidation and control over all the retirement assets.
Finally, qualified money—by law—must be consumed at some point in retirement, but definitely no later than age 70.5. So, you can only defer those taxes for so long, then the government steps in and says, “You owe us blank. Now start consuming so we can collect our taxes,” regardless of what the tax rate actually is when you turn 70.5.
A new retirement revolution
For this strategy to work, you need to reach the right market with the right situation and the right mindset. It’s not going to work for everyone, but if you can focus your efforts on those younger than age 50, it makes the most sense.
First, roll over all the orphaned 401(k) plans and other qualified accounts into one individual retirement account (IRA)—but not just any IRA, an IRA annuity with a guaranteed lifetime withdrawal benefit (GLWB). In addition, your client can convert that 401(k) to a Roth IRA and, from a tax perspective, it may make more sense, as all future distributions will be tax-free—however, converting today creates an immediate tax liability. For this article, let’s assume the client doesn’t convert to a Roth, as they don’t want to come up with the funds to pay the taxes today.
By moving to an IRA annuity, your clients don’t obtain any additional tax benefit—but you do have other valuable benefits not found in most other IRAs; namely the guaranteed lifetime withdrawal benefit. But should you go with an indexed or variable annuity? Specifically, we’re looking for a lifetime withdrawal benefit with the absolute highest guaranteed growth possible and the biggest up-front bonus and, today, those are only found in indexed annuities. Here’s an example:
Justin Case, age 45
- Ex-employer No. 1: 401(k) balance = $41,000
- Ex-employer No. 2: 401(k) balance = $36,000
- Ex-employer No. 3: 401(k) balance = $23,000
Roll over the entire $100,000 into a 10 percent up-front bonus contract with an 8 percent guaranteed growth factor. By age 65, that annuity with the lifetime withdrawal rider has a benefit value—not contract value—of $753,332. Then, at age 65, the client can start a guaranteed annual lifetime income of about $41,433, regardless of how long they live—without ever annuitizing the contract. How’s that for a guaranteed retirement income and not putting an additional penny into a qualified plan after age 45? But, if we maintained the qualified nature of this money and didn’t convert it to a Roth, all of the money consumed from the annuity will be taxed as ordinary income. Let’s now consider lessening the impact of taxes and offsetting the risk of premature death.
Not a one product solution
The second step involves making a change with the qualified plan funding. Let’s assume the client was putting $1,000 a month into the qualified plan. Well, that $1,000 was pre-tax money, so after-tax we’re looking at approximately $650. Suppose the client uses those dollars to purchase an indexed universal life insurance policy. Why life insurance? Because the client receives tax treatment similar to a Roth, but without the funding, distribution or income-limit restrictions.
With cash-valued life insurance your clients receive tax-deferred growth coupled with tax-free income. I can’t tell you how often I hear from younger people that they wish they could put more money into a Roth. Try this quick little question on your prospects and watch in amazement by the results, “If you could contribute more than the maximum amount to a Roth, how much would you contribute on an annual basis?” Chances are clients will say they’d put in more than the maximum. Then hit them with your follow-up question, “If I could show you a product that has similar tax advantages as a Roth without the funding restrictions (or income limitations), how interested would you be in purchasing that product?”
Again, clients will likely show interest; then hit them with the logical alternative—life insurance—yes, life insurance. Don’t be ashamed to offer the right product for the right need. If we stopped funding the qualified plan, most people could stuff $8,000 or more annually into the policy. Why IUL? Because some carriers offer 15-percent caps without market risk and, over the long-term, an IUL can outpace every variable universal life (VUL) product in the market today.
Justin Case, age 45, preferred non-smoker
- IUL monthly premium: $650 to age 65
- Cumulative premium to age 65: $163,800
- Initial death benefit: $376,471
- Age 66 projected cash value: $346,242
- Age 66 projected annual income: $49,472
When you combine the guaranteed lifetime annual withdrawal from the annuity ($41,453), with the projected income from the IUL ($49,472), you’ve just created an annual income for your client of more than $90,000. About 46 percent of this money will be taxed at ordinary income and 54 percent paid to the client without the impact of income taxes when structured properly. Again, clients generate all this retirement income without contributing one penny to qualified plans after making the switch. However, if the client’s employer provides matching funds, you could keep contributing a small amount of money to the 401(k) to take advantage of the matching funds. But, even if you didn’t, what average client wouldn’t like an annual retirement income of $90,000?
The power of the GLWB creates the income base so the client can rest easy at age 65, knowing that regardless of market performance, terrorist attempts, natural disasters, etc., they have a specific and guaranteed lifetime income. The beauty of the life insurance contract is it works much like a super-powered Roth. The client can contribute as much as they’d like to the policy—receive tax-free income at retirement and offset the risk of premature death. If you have clients reaching the mid-life crisis, offer them a new approach to retirement income. This new powerful combination provides a guaranteed income regardless of future performance from the annuity, with an additional tax-free income from the life policy. It’s really quite simple.