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Shattering some common myths about the 401(k)

“So, we’d like you to do for our son what you did for us,” Roberta, a long-time client of mine, told me in a meeting not too long ago. “I know we were skeptical 15 years ago, but it has worked out so well for us, we believe it would be great for him as well.”

The interesting thing about this conversation is it came on the heels of my interaction with Mark and Bill, the subjects of my previous column. It was the second time in about a week that a parent brought up their kids as a result of working with us, so I guess we are doing something right. It was also the second time that a parent who was very close to retirement promoted the belief that what is good planning later in life is good planning earlier in life. Frankly that’s one of the biggest hurdles we have to overcome to properly serve our clients.

Does it really make much sense to believe your financial objectives and strategies in your mid-60s should resemble those in your mid-20s? Think about it. In your 20s, you are just starting out in life. You are establishing your place in the world, building a future, more likely a family, and taking on responsibilities you will carry for decades. In your 60s, much of that is behind you. You have built and lived your life, established your family, and in many cases made your mark on the world. Even though life is not done, and there is often plenty of time and opportunity left to continue to impact the world around you, it’s not the same.

So why would you want to have a financial plan that is the same? As a young person, you are building, growing, sowing the seeds of your future, and the futures of your family members. This is a time for sowing your financial future as well. Often, market investments are appropriate, as long as there is balance. By that I mean the market should definitely be part of what you are doing, but by no means all.

So, in both cases I recommended, not what I had done for the parents, but what I believed was the absolutely best thing possible for the kids: permanent life insurance. And, in both cases, the parents pushed back, each expressing great doubt about my suggestion, and apparently, my financial planning chops. This I found particularly ironic as in both cases the parents had reluctantly followed my advice and years later had brought their children in to see me because they were so happy with the results. Go figure…

I have seen this many times before so I knew what to say. When Roberta said, in response to my suggestion, “Steve, I need to tell you I am disappointed. I ask you to help my children with their financial future, and all you want to do is sell them life insurance, and permanent life insurance at that,” I knew exactly how to respond: “Why do you object?”

“Because everything I have heard and read says permanent life insurance is a bad investment. Everyone knows you should buy term and invest the difference. And besides, why does he need life insurance at this age. I think he should be building a nest egg he can use in retirement, not buying a bunch of expensive insurance he doesn’t need,” she replied.

“I couldn’t agree more,” I said. “That’s exactly why I recommend it. Let me explain.”

Then I relayed the case I built for Bill. Bill is 29 and just starting out in a very well-paid position that will allow him to fund a very nice nest egg for retirement. He has about $2,000 a month to work with, which is a lot. It’s important to note this will work with much lower amounts as well. The bottom line, however, is if Bill were to purchase about $2.5 million in life insurance and fund it with $2,000 per month until age 60, he will have enough to provide around $280,000 per year in tax-free retirement income when he turns 65. Income that will last for the rest of his life. Did I say tax-free?

This is huge. By comparison, if he contributed the same amount to a 401(k) over the same period of time, he will have enough money to generate taxable income of about $102,000 per year, assuming a 7.2% annual growth rate and a 4% payout in retirement. That’s only 35% the amount generated by the life insurance. And, since it’s taxable, it’s worth even less. Worse, it isn’t guaranteed. In today’s world, a 4% payout will only last 30 years less than 50% of the time.

But what about the tax deferral and the company match of the 401(k)? While I don’t want to get into the math here, if you assume a 6% match and tax deferrals based on a 15% effective tax rate, and you added all that money back into the 401(k) contributions, it brings the income to $125,000 per year. Also taxed and not guaranteed for life.

In addition to the superior retirement planning results from the life insurance, there are other major benefits. For example, the ability to access the funds any time, tax-free, for literally any purpose. When you pay the money back, you are paying yourself. When you pay interest, you are also paying yourself. In addition, it sets the young client up for financial protection for his or her growing family should they meet an early demise. It can also be used as a college fund, a source of financing for automobiles, houses, etc., as well as a source of money for long-term care and other life events.

But that’s not even the best part, because when you borrow and use the money, it also still remains in the insurance policy, continuing to collect interest, even while you are using it to finance something else. We call that free money.

Try that with your 401(k).

Stephen Kelley is a recognized leader in retirement income planning. Located in Nashua, he services Greater Boston and the New England areas. He is author of five books, including “Tell Me When You’re Going to Die,” which deals with the problem unknown lifespans create for retirement planning. It and his other books are available on Amazon.com. He can be heard every weekend on the “Free to Retire” radio show on WCAP and WFEA, and he conducts planning workshops at his New England Adult Learning Center, located in Nashua. Initial consultations are always free. You can reach Steve at 603-881-8811 or at www.FreeToRetireRadio.com.