Qualified plans like the 401k are like “sacred cows,” as Garrett Gunderson so aptly calls them in his book. Since the 401k was established, it's been the darling of the financial media. It's the “one-size-fits-all” solution to retirement planning… if typical finance is to be believed. However, when you take a Prosperity Economics approach, the 401k and other qualified plans fall apart. And with the TC Qualified Plan calculator, you're positioned to share the whole truth about qualified plans.
While we're going to focus on the 401k for this demonstration, you can use this calculator to assess any qualified plan. This includes: IRAs, the 403b, profit-sharing pension plans, and other government qualified plans.
Setting Up a 401k in the Qualified Plan Calculator
For the purposes of this demonstration, let's look at a 401k over 30 years. We'll set the Current Age to 35, and the Projected Age to 64. This client's currently has $100,000 in his 401k, which we'll input into the Present Value section. His earnings rate is 8%. So what we see is that even if he never contributed another dollar, that account is projected to grow to just under $1.5 million NET.
Let's say the client adds $10,000 a year to his account—every year for 30 years. His rate of return isn't going to change, yet those contributions will take his account to a little over $3.3 million.
The Benefit of the Qualified Plan
Now that we have a baseline for the client's 401k, let's get into the benefit of the qualified plan. In other words, let's analyse the reason this client likely opened a 401k in the first place: the tax deferral and the employer match.
What people commonly misunderstand about the tax benefit of the 401k is that you're not getting a tax credit applied to your 401k. The government isn't just putting a little extra money in there for you. What you actually get is a tax deferral. This means that you can make your 401k payment with pre-tax dollars. However, those taxes will eventually come due, and they come due on the account growth. (We'll get to that later.)
For now, let's just input the tax information for this client. Let's say his income, after deductions, is $65,000. When you click on the Tax Deferral Button, you see the impact of the deferral. While the rate of return increases to about 8.5%, the actual impact of the deferral is only about $366,000.
The Employer Match
The client also benefits from the employer match, right? Let's say his company gives him a 50% match. This is often what the clients hear, and therefore expect. However, most companies don't actually match a full 50% of the contribution. There's a limit at which they stop matching, and in this instance, let's say it's $2,500. When we do this, we see the ROR jumps just a tiny bit higher. The NET employer match is about $368,000, which represents the contribution compounded over 30 years. And overall, the account finally surpasses $3.5 million.
The Costs of a Qualified Plan
So far, so good, right? The client's account is growing to over $3.5 million, so everything is on track. While things may looks great, it's time to look at the costs of the 401k. We're talking fees and taxes that eat away at that wealth.
Let's start with a Management Fee. To start, we'll use a conservative number of 2.5%. If you look at the lefthand color key, you'll see that the client only paid about $600,000 worth of fees. However, the actual account balance is now only about $1.7 million. So what happened to the other $1.3 million? That money that seemingly vanished into thin air was the compound growth of the account. When the fees were charged, the account lost some of its compounding power. You'll notice that the net deferral and employer contribution have also decreased, because they've lost compounding power too.
The Cost of Taxes
To make a bleak situation a bit more bleak, we have to remember that the client is only going to get that remaining $1.7 million if he pays taxes. Remember that tax deferral? So if we click the Tax Cost button, we get a look at the full tax obligation for the client's 401k. In other words, this would be the tax cost if he liquidated the account at age 64. So in order to get his $1.7 million, the client has to pay almost $600,000 in income taxes. By the time he touches the money, he's looking at $1.1 million. And if you take a look, the ROR of the account is less than 4.5% now.
How Much Income from the Qualified Plan?
While there's still some interesting data you can play with in the Qualified Plan calculator, it's pretty clear that it's not as high-performing as the financial media makes it out to be. While that initial $3.3 million would have been fairly substantial, the $1.1 million the client has left isn't much.
In case you had any doubts, consider how long the client can draw income from this account. If he wants to maintain his lifestyle of $65,000 a year, he'll have to withdraw more than $210,000 annually, according to this Future Value calculator. And that's just if inflation is only about 4%.
This suggests that the client will have just over 5 years' worth of retirement income. At the end of the day, what seems like a supercharged savings account is actually a very limited plan that benefits the government the most.
An Alternative to the Qualified Plan
It's also interesting to note that at this time, the client probably doesn't have the capacity to buy a large whole life insurance policy. Or at least, not up to his human life value. This means he'll either buy temporary term insurance, or go without coverage.
If he contributed instead to a whole life insurance policy, he could have an all-purpose account to access at any time for any reason. There would be no management fees or penalties, and he could access it without interrupting the compound growth. In addition, he could access it virtually tax-free (if done properly), and it will pass to his heirs tax-free. If he doesn't want to give up his “free money” from his employer, he could contribute up to the match in his 401k, and the rest into whole life.
This way, his money will be safe and certain with the life insurance company. And at the end of the day, his family will be protected as well.
To learn more about the Qualified Plan calculator and how to use it, join us at a Truth Training. You'll learn how to use each and every calculator to tell important stories and the whole truth about money.
If you're interested in learning how to advance your practice by leveraging technology to connect with your clients, read our article about AI in life insurance.