We will use a case study to illustrate.
401(k) As Retirement Tool
- Male age 35
- Contributes $18,000 per year to 401(k) till age 60
- Retire at age 61
- Average annual 401(k) return 8% during working years, 5% during retirement years
- Average 401(k) expense ratio is 0.5%
- Tax rate (Federal plus State) is 33%
- During retirement time, desired annual after-spending retirement income is $63,346 (we will explain how this number was derived below)
After 25 years' 401(k) savings, this person's 401(k) balance at retirement age 60 is $1,433,374! However, just to support a modest $63,346 per year retirement use of money, the 401k will run out of money at age 91! (For most people, the results will be far worse, 401k typically runs out of money in the age 70's or 80's.)
Also, no legacy will be left behind as 401k saving is fully depleted.
IUL as Retirement Tool
Now, assume this person doesn't contribute the $18,000 to 401(k), instead, after paying income tax at 33%, save $12,060 per year to an IUL account.
Assume average IUL annual return is 7% (lower than the 401(k) return during working years but higher than 401(k) return during retirement years, because with downside protection, IUL could stay fully linked to equity market performance).
At retirement age 60, IUL's cash value balance is $762,854, nearly half of 401(k) balance.
Does this mean IUL is a bad choice for this person?
Life During Retirement Time
The answer is NO, for a simple reason - no conclusion should be made based on the results at age 60, because this person just starts his retirement life at age 60! IUL will catch up and become a winner in the end due to some special benefits that 401(k) cannot match!
IUL Benefit 1. Keep Growing at Retirement Time
With downside protection, the IUL's cash value can afford to be fully tied to equity index performance, resulting in better average annual return. Compound that with 20-30 years of retirement time, the incremental growth will be substantial compared with the more conservative 401k growth during retirement years.
IUL Benefit 2. Tax-free Loan
During the retirement time, this person could borrow $63,346 each year as supplement retirement income from IUL, tax-free, thanks to life insurance's 7702 rules (401k needs to take out $94,546 pre-tax for the same after-tax amount).
IUL Benefit 3. Participating Loan
Utilizing IUL's participating loan feature (which means the loan balance will continue to grow with the remaining cash value), the loan is actually making money for the person (assumed average loan rate 5.8% - the product we chose to run the illustration actually has a 6% cap for loan rate, lower than the average IUL annual return).
401(k), or any other investment account, has no such feature, when $94,546 is withdrawn each year out of 401k, the account balance will gradually decline. If the stock market crashes in a year, the result could be devastating (take higher percentage out at the low point of the account balance).
The Bottom Line
Unlike 401k that will run out of money at age 91, the IUL still leaves a net death benefit of $600,000 for beneficiaries, tax-free, if the policy ower dies at age 91.
We made a near apple-to-apple comparison between 401(k) and IUL, the results is that IUL could not only supplement the same amount of retirement income, but also leave a legacy to the children, tax-free.
Another benefit by keeping IUL as part of the portfolio, the other portfolio could be kept at a more aggressive mode, so when the bad market hits, one can rely on money from IUL, one the good market comes, one can take money out of other accounts.
In our next blog post, we will provide a summary of the Pros and Cons of IUL, and the implications.