Retirement-Savings Strategies for High Earners

Here's a piece from SmartMoney's Ask SmartMoney series. It starts with the following question:

I'm a 37-year-old physician with an annual income of about $500,000. I max out my 401(k) plan, and don't qualify for a Roth IRA. I'd like to make additional contributions to retirement savings, and have looked into using whole life insurance as an option for tax-deferred savings. Is that a wise idea, or should I look to more conventional investments options such as stocks, mutual funds or real estate? When is whole life a good investment, and how much should be invested in it?

Here's (the important part of) SmartMoney's answer:

Maxing out a 401(k) is a great first step toward securing a comfortable retirement. For many people, however, it's not enough. Someone making $500,000 a year would need a nest egg worth $8 million to $10 million in today's dollars to maintain his or her lifestyle in retirement, says Harold Evensky, a certified financial planner based in Coral Gables, Fla. Investing in a whole life insurance plan, however, isn't the best way to get there. Here's why.

Whole life can make sense in a number of situations, including estate planning, but it should never be used as a primary investment vehicle for people simply looking for tax-deferred savings, says Evensky. Remember, this is a life-insurance product. In order to get the death benefit, the providers charge a pretty hefty administrative fee and commission that can slash annual investment returns by as much as three percentage points. Policyholders are also charged surrender fees if they choose to abandon the product before a certain date.

For investors who are dead set on finding a tax-deferred savings vehicle, variable annuities are a better option. The administrative fees tend to be much lower than those for whole life. Vanguard, for example, says it offers a product with an annual fee of just 0.58%, compared with the industry average of 2.35%.

While variable annuities can make sense for the tax-weary, however, they aren't a panacea, says Patricia Powell, a certified financial planner based in Martinsville, N.J. They're more expensive than many mutual funds, and when it comes time to make a withdrawal, the money is taxed as ordinary income rather than capital gains, which have a maximum tax rate of just 15%. Making matters worse, Powell points out, an investor would face a surrender fee if the funds weren't held for a certain number of years, and a 10% federal penalty if withdrawals were made before age 59 1/2. In other words, your money is locked up for a long time.

A better solution for a high-earning person in her 30s is to invest in a balanced portfolio (a combination of stocks, mutual funds and bonds) with a bias toward growth, says Steven Kaye, a certified financial planner in Watchung, N.J. Since mutual fund and brokerage fees are likely to be lower than those for variable annuities, you'll accumulate more money over the long run. Sure, a balanced portfolio won't be tax-deferred, but as we mentioned earlier, the tax rate for capital gains is a mere 15%. "That's the lowest rate any of us have seen in our lifetimes," says Kaye.

I'm in a similar situation and do as they advise -- fully fund my 401k and invest the rest in taxable accounts. I do, however, make a (relatively) small side income through writing, and have been able to sock away some additional funds in a SEP IRA.

Comments

[JJ]

I keep my money in my shoe.

[George]

First, I am a fee only certified financial planner and cpa. Over my career I have seen lots of these fancy ways to beat the tax man that involve insurance. Lots of these shams are targeting physicians who very often fall for them. I think it has to do with their perceived intelligence...Doctors are smart but they are the absolute worst when it comes to handling their own money finances (actually, dentists have them beat but not by far). You need insurance, you buy insurance. You absolutely want tax deferral AND you maximized your other options AND you are in the highest tax bracket then you can go for an annuity from Vanguard only while realizing that the best option is to have a diversified portfolio and add the funds in your regular taxable account which will leave you with more even after taxes are taken into account.

The people selling these things are master salesmen and can make out in a VERY BIG way at your expense when you bite. Walk away....no RUN!

GP

[Old Niu]

Interesting topic.

I am also in a similar boat. I stayed away from whole life or variable annuity. My wife stays at home but operates a small business and we put whatever income generated in her SEP IRA.

My company also offers a nice benefit for executives to defer their income. You can choose to defer up to 50% of the base and 100% of the cash bonus to a pre-specified time. The deferred money can grow tax free in the account until it's distributed.

[Larry]

However, I believe that you have failed to take into consideration the real value of whole life insurance -- it gives you PERMISSION.

Let's assume that you have a $2M portfolio when you retire -- under the traditional approach, your primary concern is to avoid erosion of your nestegg, since it is the source of your income. Therefore, you invest it in a VERY conservative manner, and realize 4-6% after tax income. For purpose of this illustration, however, let's not consider the tax implications. So, $2M invested at 6% generates an annual income of $120,000.

Assuming that your portfolio performs as anticipated, you receive an income of $120,000 per year (disregarding inflation) for the rest of your life, and when you pass, you leave $2M to your children, church, or charity.

However, if you had an additional $2M in whole life insurance, you now have PERMISSION to spend your accumulated assets, and still have $2M to leave to children, church, or charity.

A back of the envelope calculation says that if you targeted age 85 as the day you have consumed the $2M in assets, you would be able to withdraw approximately $171,000 per year (a combination of income at 6% and spend-down of retirement assets). Further, since the additional $51K is sales of assets, it is TAX FREE, with the taxable income going down each year (because there are less assets to generate taxable income). This reduction in taxable income is offset by liquidating a larger share of the assets.

So, you get to age 85-- you have spent approximately $1M more than you would have spent otherwise (the difference between $171,000 and $120,000 for 35 years) AND you still have the whole life policy available. But, the $2M policy (the death benefit value at age 65) has grown to $4.9 million, and generates annual dividends of about $159,000. You now have two choices - freeze the insurance so there is "only" $4.9M available for church or children (all tax free), and live on $159K a year, or take tax free loans (at 5%) from the cash value of the policy to maintain your current lifestyle.

The approach previously suggested is the traditional financial planner approach - short-sighted. It is focused only on the best way to maximize the amount of captial available at retirement. It does not take into consideration the impacts during the retirement or estate portion of your financial life.

Oh, by the way -- the cost of $2M whole life insurance at age 37??? Assuming you are in good health -- about $25K a year.