A review of the tax principles used herein is also in order. Investments are made in Jerry’s tax-deferred 401(k) plan. This means that taxes are not paid initially on the plan contributions, but any withdrawals from the plan will be subject to ordinary income tax rates. At retirement, Jerry completes a rollover of his 401(k) to a traditional individual retirement account (IRA). This is not a taxable event. With a tax deferred account, the government effectively owns a portion of the account as identified by the tax rate. Taxes are deferred until withdrawals are made.
The investment account values are expressed in posttax terms assuming a 25 percent combined marginal tax rate. Life insurance premiums are paid with posttax funds. No taxes are due on the death benefit, making it a posttax number. As well, a life insurance policy can be arranged so that funds can be borrowed from the cash value without being taxed. When distributions are properly structured, cash value represents a posttax number as well.
If an income annuity is purchased at retirement, this purchase is made with qualified retirement funds in the IRA. The annuity income is then fully taxable at income tax rates as it is received from the qualified account. Because the annuity is purchased in a qualified account, someone seeking to purchase an annuity with funds equivalent to the life insurance death benefit would need to inflate their purchase to account for the differing tax treatment. For example, a nontaxed death benefit of $500,000 is equivalent to $500,000 / (1 – 0.25), or $666,667, in the IRA when the tax rate is 25 percent.
Jerry must decide whether to purchase a term life insurance policy to increase his existing coverage to meet his human capital replacement value for his family, or to otherwise purchase a whole life insurance policy that can serve his additional human capital replacement value need as well as be integrated into his retirement income strategy. From the portion of his annual savings I have outlined, he will pay for life insurance premiums and the taxes to cover those premiums, and the remainder will go into his tax-deferred 401(k) plan.
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In all scenarios, I assume that Jerry is directing at least enough to the 401(k) to satisfy the conditions for the highest possible company match, though I do not specifically model any company match when simulating retirement income. More generally, Jerry and Beth may also have other resources in retirement that I am not analyzing. I am modeling the relevant features about how to best make the investment and insurance decisions for the described annual set-asides to meet life insurance needs and to obtain the most desirable retirement outcomes.
Jerry will decide between term life and whole life insurance. The term policy lasts for twenty-five years with a $500,000 death benefit and has an annual premium of $2,282. Taxes on the pretax income required to cover this premium are $761. After paying the term life premium and taxes, he contributes the remaining $15,957 to his 401(k). As mentioned, these savings increase over time with inflation following the employee contribution limit increases on the 401(k), while life insurance premiums remain fixed.
The whole life policy Jerry considers also carries a death benefit of $500,000. The annual premium is $6,873. The policy accrues cash value that can serve as an additional spendable asset for the household and that helps to reduce future insurance costs relative to the term policy. The policy is designed to have premiums paid until age sixty-five. At this age, the policy becomes fully paid up. Subsequent insurance costs are covered by the cash value. The policy endows at age 100 when the cash value grows to match the value of the death benefit. Taxes to cover the whole life premium are $2,291. With a whole life policy, Jerry can contribute $9,836 to his 401(k) at age forty, with that value subsequently growing with the described contribution limits.
An important methodology issue for the case study relates to asset allocation. With a whole life policy, the cash value is a liquid asset contained outside the financial portfolio. It behaves like fixed-income, though it is not exposed to interest rate risk (i.e. the accessible cash value does not decline when interest rates rise). Cash value is not precisely the same as holding bonds in an investment portfolio, as there is not a practical way to rebalance the portfolio between stocks and policy cash value. As well, the premium for an income annuity can be viewed as a fixed-income asset. It is not liquid, but it is repositioning assets into the insurance company general account to support protected lifetime income.
I assume that Jerry will incorporate the cash value of life insurance and any annuity premium into his asset allocation decisions to maintain the overall proportion between stocks and bonds for household assets. For example, if the target date fund calls for a 50 percent stock allocation, then the actual stock allocation Jerry uses will be 50 percent of the sum of the financial portfolio balance, the pretax value of life insurance cash value, and any annuity premium already paid, divided by the portfolio balance.
Though this could conceivably call for a stock allocation of greater than 100 percent when the actuarial bond holdings (annuities and cash value life insurance) are large relative to the financial portfolio, I constrain the maximum possible stock allocation for the financial portfolio to not exceed 100 percent. This higher stock allocation in the investment portfolio can be justified because it is just one part of the asset base and the goal is to maintain a particular stock allocation in relation to overall household assets rather than just to the investment portfolio. This does require the retiree to accept this line of thinking.
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*This is an excerpt from Wade Pfau’s book, Safety-First Retirement Planning: An Integrated Approach for a Worry-Free Retirement. (The Retirement Researcher’s Guide Series), available now on Amazon