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Is Now the Perfect Time to Dump Your - 401(k)/Profit Sharing Plan?

By Roccy M. DeFrancesco, JD, CWPP™, CAPP™ - Email Editor

Date : March 26, 2009

Dear Valued Reader,

This newsletter needs to be prefaced by stating that if you are not a business owner, it might not initially sound like a newsletter you'll want to read. That is not the case. If you are a w-2 employee, this newsletter can still be valuable to you by reading the end of it where I discuss alternative funding vehicles vs. a tax-deferred 401(k) plan.

Conventional advice to build wealth

If you are a business owner in the 35% income tax bracket, you can choose to income tax-defer let's say $45,000 into a 401(k)/Profit Sharing Plan (PSP) that can grow “tax-deferred” for years; or you can choose to take home $29,250 after paying income taxes to invest for retirement. Business owners so despise the IRS that they cannot wait to income tax-defer the maximum amount of money into “tax-deferred” qualified plans.

Does that make sense? Let's look at an example with a 45-year old small business owner who is now and will be in the 35% current income tax bracket in retirement. The client will income tax-defer $45,000 into a 401(k)/PSP which will be compared to investing $29,250 after-tax in a brokerage account. Assume a 1.2% mutual fund expense on money in both accounts and a 20% blended capital gains/dividend tax on the annual growth in the after-tax brokerage account. Assume a 7% annual growth rate on both accounts. Finally, I will assume that the client will draw down both accounts from ages 66-85 where at age 85 both accounts will be zero.

Assume that our business-owner client has four employees making $35k, $45k, $55k, and $75k a year; and that, in order to “max-out” the qualified plan for the owner, a 6% across-the-board contribution must be made for the employees. The total employee compensation is $210,000 a year, and 6% of that is a $12,600 a year contribution. Let's also assume a $1,000 TPA fee to administer the 401(k)/Profit Sharing Plan.

$13,600 x .65 = $8,840 (the amount the business owner could take home after-tax to build wealth if he/she didn't have to fund a qualified retirement plan for employees).

Which one will provide more after-tax income in retirement? Did you guess the income tax-deferred qualified plan? Let's look at the “real world” numbers.

	Annual	Value at age 65	Taxable	After-Tax
	Contribution		Withdrawals	Withdrawals
Tax-Deferred Qualified Plan	$45,000	$1,861,202	$150,892	$98,079
After-Tax Investing	$38,090*	$1,367,609	N/A	$101,697
Difference				($3,618)

*$38,090 = $29,250 + $8,840.

That's interesting. When I factor in the actual costs of the employees, using an income tax-deferred plan didn't work out so well.

Changing the variables

What if the example client has NO employees and chose NOT to fund a tax-deferred retirement plan? How much could be removed from the after-tax brokerage account? $78,095 (thus showing the power of income tax-deferring money for retirement).

What if the client has NO employees and NO tax-deferred retirement plan and is in the 25% tax bracket now and 35% when in retirement? $90,100 (from the after-tax brokerage account).

The Stock Market Crash is your excuse to dump your company's pension plan

The recent stock market crash and the crummy economy, while not good for anyone, has opened up a window of opportunity for business owners to get rid of their qualified retirement plans. Few employees today would question an employer for getting rid of an employee-benefit perk right now. Most employees are happy to have jobs, and the chances of ill will being created because of the removal of a retirement plan is slim.

Funding cash value life insurance after-tax instead of a tax-deferred qualified retirement plan

Most people do not understand how using a cash value life insurance policy can be used to grow a tax-favorable retirement nest egg. A properly designed cash value life insurance is a unique wealth building tool that once funded allows money to grow tax-free and come out tax-free in retirement.

What if the example client funded Revolutionary Life in the amount of $38,090 every year after-tax for the same time frame and removes the maximum amount of income tax-free loans from the policy from ages 66-85 (assuming a gross rate of return of 7%)? How much could be removed from the policy?

$166,010 (with wash loans each year from ages 66-85)

$196,513 (with a 1.5% variable loan each year from ages 66-85)

What if the example client only placed $29,250 into Revolutionary Life?

$127,283 (with wash loans each year from ages 66-85)

$150,788 (with a 1.5% variable loan each year from ages 66-85)

Remember, $29,250 is the amount of after-tax money that would be available in the first example if the client had NO employees and chose not to implement a tax-deferred retirement plan.

Summary

I am NOT telling you that tax-deferred retirement plans are evil or bad. I am a huge proponent of proper “asset allocation”. So having a tax-deferred qualified plan may be a good idea for many who read this newsletter.

However, many business owners may be better off by getting rid of their current qualified retirement plans due to the costs for the employees.

Additionally, because many people (owners and w-2 employees) are not aware of the power of growing wealth through the use of a properly designed cash value life insurance policy, I thought this newsletter might be a bit of an eye opener.

If you would like more information on Revolutionary Life and how it might work to help you build tax-favorable wealth for retirement, or if you would like to discuss your business's qualified retirement plan, please feel free to email us.

Until next time,

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