Qualified plans, such as the 401(k), are like “sacred cows,” as Garrett Gunderson aptly calls them in his book. Since the 401(k) was introduced, it has 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 401(k) and other qualified plans fall apart. And with the Truth Concepts Qualified Plan calculator, you’re positioned to share the whole truth with your clients.
While we focus on the 401(k) 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 401(k) in the Qualified Plan Calculator
For this demonstration, let’s look at a 401(k) over 35 years. We’ll set the Current Age to 30, and the Projected Age to 64. This client 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 [See Figure 1.1].
Let’s say the client adds $10,000 a year to his account every year for the next 35 years. [See Figure 1.2]
His rate of return won’t change, yet those contributions will take his account to a little over $3.3 million. Essentially, just by adding a contribution, he can more than double his results over 35 years.
Yet consider this: a $100,000 contribution makes him $1.5 million. Yet another $350,000 only makes him another $1.8 million. So what’s really going on here?
The Benefit of the Qualified Plan
Now that we have a baseline for the client’s 401(k), let’s get into the benefits of the qualified plan.
In other words, let’s analyse the reason this client likely opened a 401(k) in the first place: the tax deferral and the employer match.
What people commonly misunderstand about the tax benefit of the 401(k) is that it’s not a tax credit. The government isn’t just putting a little extra money in there for you, or giving you a little extra money back on your tax return.
What you actually get is a tax deferral. This means that you can make your 401(k) contributions with “pre-tax” dollars, and while it grows, you don’t have to pay taxes on the growth… yet. 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 input the tax information for this client [See Figure 1.3]. Let’s say his income, after deductions, is $65,000. When you click on the Tax Deferral Button, the deferral is reflected in the Net Contributions for ease, effectively “saving” the client $54,000 over 35 years.
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, yet it doesn’t turn out how they expect.
Most companies don’t 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. This means that they will match 50% of $2,500 maximum.
When we do this, we see the ROR jumps just a tiny bit higher [See Figure 1.4].
The NET employer match is about $368,000, which represents the contribution compounded over 35 years.
Overall, the account is now over $3.5 million.
Fun Fact: If you’re following along on your own calculator, you’ll notice that before turning on the Max Contribution Matched the account value jumps to $4.2 million. It goes to show what a big impact capping the max contribution has. So much for “free money.”
The Costs of a Qualified Plan
So far, so good, right? The client’s account will grow to over $3.5 million, so everything is on track….
Yet, while things may look great now, it’s time to factor in the costs of a government-sponsored plan. 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 left-hand color key, you’ll see that the client pays about $765,000 worth of fees over 35 years [See Figure 1.5]. For $3.5 million, that’s a small price to pay, right?
However, the actual account balance is now only about $2.1 million. So what happened to the other $600,000?
Well, the money that seemingly vanished into thin air was the compound growth of the account. By charging fees, the account loses some compounding power and is unable to build the same momentum. 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 $2.1 million if he pays taxes.
Remember that tax deferral? Yeah, it’s coming back to bite.
If we click the Income Tax Cost button, we get a look at the full tax obligation for the client’s 401(k). In other words, this would be the tax cost if he liquidated the entire account at age 64.
So, to get his $2.1 million, the client has to pay more than $700,000 in income taxes [See Figure 1.6]. By the time he EVER touches the money, he’s only looking at $1.4 million. And that’s after contributing $400,000. It’s certainly an improvement, yet it stings to know what could have been without fees and taxes.
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 $3.5 million would have been fairly substantial, the $1.4 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 when he’s 64, he’ll have to withdraw more than $256,000 annually, according to this Future Value calculator [See Figure 2.1]. 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. However, he will also have to calculate the tax cost of those dollars, and add that to his withdrawal.
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 can’t 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 try out the Qualified Plan calculator for yourself, download a Free Trial of Truth Concepts today. You’ll get access to the full software, as well as some quick-start videos to get you started.
Want a step-by-step video? Check out this demo of an older version of our Qualified Plan calculator to see it in another way.
4 Responses
Really love the education, and I dont even sell insurance :). Question – do you know of any recent/good research on cost of qualified plans (the 2.5% you mentioned in this article). Seems to be so little out there. Is that 2.5% inclusive of the investment choices? (thus ETF investors would have significantly less fees than mutual fund). Thank you.
Thanks, Paul. We’ve not found much either, yet usually feel that there are management fees, trading fees, third party administrative fees and possibly trustee fees or others on top, many of which are not disclosed.
Excellent, great information. The public needs to be so educated about this, they just don’t know what they don’t know and that is very costly to them.
Thank you, Jon!