Spreadsheet Goodness
This is part 3 of a 3-part series.
Download the spreadsheet as:
In parts 1 and 2, we looked at retirement and taxable accounts. Now let's really dig deep into the rabbit hole.
Non-deductible IRAs
Say you have the option to put money in a non-deductible IRA? Is that the better option than putting it in a taxable account? Non-deductible IRAs defer taxes on growth until withdrawal with qualified capital gains/dividends converted to regular income.
The ending $29K number is less than holding taxable index funds. The only case this would make sense is for REITs, Bonds or high-turnover stock picking.
Variable Annuities
Variable annuities act just like non-deductible IRAs. You can treat the two the same except for two differences. (1) No limits on contributions. (2) It uses a nominal insurance contract to provide tax deferred growth which requires extra expenses (mortality risk expense) to pay for the insurance. Now if you called up Vanguard directly to open a VA, they would charge you a 0.30% M/E in addition to their standard fund expenses. (Other companies offering low-cost VAs include Fidelity at 0.25% and Jefferson Mutual at a fixed $240/year.) In this case, we modify the return from 10% to 9.70%.
The ending number is just a tad below a taxable account holding a diversified index portfolio so I would not use a VA to hold any investment that has a significant amount of qualified gains. On the other hand, if you have used up all money in your 401K/IRA/Roth IRA/HSA, using a VA to hold Bonds and REITs may produce better results than forcing other high yields into taxable. From these numbers, it does not "seem" like the complete ripoff people constantly say VAs are.
Variable Annuities Part 2
Unfortunately, low-cost VAs are not the norm in the industry. The typical insurance company will charge M/E of 0.75% to 2%. Let's use 1.25% as the average and see what happens.
This number is just slightly higher than the 100% income rate taxable option. Great, you saved on taxes -- too bad all the tax savings went to the insurance company. (Politically/economically, would it be better for an insurance company to earn profits versus the government collecting taxes? Well that's a totally different discussion.)
There are specific instances where a high-cost VA can provide some interesting benefits. For example, if you can't get life insurance due to health problems, some companies offer a death benefit rider to their VAs which may give you enough coverage for funeral expenses and a bit of inheritance tax.
Permanent Insurance: Whole Life, Universal Life, Variable Universal Life
Now let's kick this spreadsheet into high gear. Suppose you have an agent hot on your heels to sell you some type of permanent life insurance policy. First, if you don't max out your 401K/IRA/Roth IRA/HSA, there's no need to consider -- get term life and invest the difference. But say you do that already, you meet your desired allocation target in low tax-drag taxable accounts and you still have plenty of money to invest. Before we start popping numbers into our spreadsheet, we must look through a prospectus with a fine-toothed comb. From reading through a Western Reserve Variable Universal Life (VUL) prospective, I extracted out the following costs:
100K VUL -- Target Premium
If tax rates stay the same, the 100K VUL will never catch up to the taxable portfolio. Now we are in historically low tax rates -- especially for long term capital gains and qualified dividends. In what kind of tax environment would this policy catch up after 30 years? So we go over to the Taxable Tax Rate cell and slowly increase the number. Right about 30% is when the two 30 year numbers match ...
... With major caveat. The "tax free" benefit of permanent insurance comes in the form of loans against the policy. At the time of passing, the death benefit payout pays off the loan leaving the remainder for your heirs. This means if you "borrow" money from your policy, it must remain in force or otherwise a total disaster occurs -- all money borrowed immediately gets converted to taxable income! So in effect, you can only tap some percentage of your policy for your own use with. In this case, I've randomly guessed 80% as the number.
250K VUL -- Target Premium
With lower sales load starting at the 250K threshold, this improves the VUL performance by ~3% over the full sales load but still not a very enticing option.
500K VUL -- Target Premium
With no sales load, this policy's total cash value almost matches the taxable portfolio after 30 years.
100K VUL -- 7-pay
For almost everybody, insurance is an absolutely horrible investment vehicle. However, there is a small subset that might be able to benefit from it. The Standard Unit Charge appears to be a fixed amount per year. To make it a smaller percentage, put more money in. For a mid-30's non-smoker, the quote I received says the IRS will allow annual contributions up to about 3.5% of policy face for 7 years. (This is called 7-pay because you fully fund your policy in 7 years.)
In this calculation, we bumped up the Max Borrow amount to 90% due to the larger CashValue:PolicyFace ratio.We see the 100K VUL funded at 7-pay limits catches up to a taxable portfolio after 30 years versus never at the target premiums.
250K VUL -- 7-pay
Break even at 17 years.
500K VUL -- 7-pay
Getting rid of the sales load has brought break even point to about 6.5 years. Sounds like a viable option -- assuming:
Final Words
Remember all numbers and projections I showed here are mere samples. Don't come away from these articles with the idea that X is always better than Y. It will always be up to you to do due diligence on your own situation and options. Research, analysis and critical thinking -- use your brain and it will be your most important tool to evaluate investments. Download and have at it.
This is part 3 of a 3-part series.
Download the spreadsheet as:
- OpenDocument: InvestmentTaxSummary.ods
- Excel: InvestmentTaxSummary.xls
In parts 1 and 2, we looked at retirement and taxable accounts. Now let's really dig deep into the rabbit hole.
Non-deductible IRAs
Say you have the option to put money in a non-deductible IRA? Is that the better option than putting it in a taxable account? Non-deductible IRAs defer taxes on growth until withdrawal with qualified capital gains/dividends converted to regular income.
The ending $29K number is less than holding taxable index funds. The only case this would make sense is for REITs, Bonds or high-turnover stock picking.
Variable Annuities
Variable annuities act just like non-deductible IRAs. You can treat the two the same except for two differences. (1) No limits on contributions. (2) It uses a nominal insurance contract to provide tax deferred growth which requires extra expenses (mortality risk expense) to pay for the insurance. Now if you called up Vanguard directly to open a VA, they would charge you a 0.30% M/E in addition to their standard fund expenses. (Other companies offering low-cost VAs include Fidelity at 0.25% and Jefferson Mutual at a fixed $240/year.) In this case, we modify the return from 10% to 9.70%.
The ending number is just a tad below a taxable account holding a diversified index portfolio so I would not use a VA to hold any investment that has a significant amount of qualified gains. On the other hand, if you have used up all money in your 401K/IRA/Roth IRA/HSA, using a VA to hold Bonds and REITs may produce better results than forcing other high yields into taxable. From these numbers, it does not "seem" like the complete ripoff people constantly say VAs are.
Variable Annuities Part 2
Unfortunately, low-cost VAs are not the norm in the industry. The typical insurance company will charge M/E of 0.75% to 2%. Let's use 1.25% as the average and see what happens.
This number is just slightly higher than the 100% income rate taxable option. Great, you saved on taxes -- too bad all the tax savings went to the insurance company. (Politically/economically, would it be better for an insurance company to earn profits versus the government collecting taxes? Well that's a totally different discussion.)
There are specific instances where a high-cost VA can provide some interesting benefits. For example, if you can't get life insurance due to health problems, some companies offer a death benefit rider to their VAs which may give you enough coverage for funeral expenses and a bit of inheritance tax.
Permanent Insurance: Whole Life, Universal Life, Variable Universal Life
Now let's kick this spreadsheet into high gear. Suppose you have an agent hot on your heels to sell you some type of permanent life insurance policy. First, if you don't max out your 401K/IRA/Roth IRA/HSA, there's no need to consider -- get term life and invest the difference. But say you do that already, you meet your desired allocation target in low tax-drag taxable accounts and you still have plenty of money to invest. Before we start popping numbers into our spreadsheet, we must look through a prospectus with a fine-toothed comb. From reading through a Western Reserve Variable Universal Life (VUL) prospective, I extracted out the following costs:
- Sales Load
- 6% for policies $0-$250K, years 1-10
- 2.5% for policies $0-$250K, years 11+
- 3% for policies $250K-$500K, years 1-10
- 2.5% for policies $250-$500K, years 11+
- 0% for policies $500K+
- Standard Unit Charge
- 0.096% of policy face value, years 1-10
- 0%, years 11+
- M/E
- 0.75% years 1-10
- 0.60% years 11-15
- 0.30% years 16-20
- 0% years 21+
- Average fund expense ratio: 0.75% (+0.50% higher than Vanguard funds)
- Cost of insurance: we will ignore this component for simplicity purposes -- the assumption here is you would pay this cost through term coverage also
100K VUL -- Target Premium
If tax rates stay the same, the 100K VUL will never catch up to the taxable portfolio. Now we are in historically low tax rates -- especially for long term capital gains and qualified dividends. In what kind of tax environment would this policy catch up after 30 years? So we go over to the Taxable Tax Rate cell and slowly increase the number. Right about 30% is when the two 30 year numbers match ...
... With major caveat. The "tax free" benefit of permanent insurance comes in the form of loans against the policy. At the time of passing, the death benefit payout pays off the loan leaving the remainder for your heirs. This means if you "borrow" money from your policy, it must remain in force or otherwise a total disaster occurs -- all money borrowed immediately gets converted to taxable income! So in effect, you can only tap some percentage of your policy for your own use with. In this case, I've randomly guessed 80% as the number.
250K VUL -- Target Premium
With lower sales load starting at the 250K threshold, this improves the VUL performance by ~3% over the full sales load but still not a very enticing option.
500K VUL -- Target Premium
With no sales load, this policy's total cash value almost matches the taxable portfolio after 30 years.
100K VUL -- 7-pay
For almost everybody, insurance is an absolutely horrible investment vehicle. However, there is a small subset that might be able to benefit from it. The Standard Unit Charge appears to be a fixed amount per year. To make it a smaller percentage, put more money in. For a mid-30's non-smoker, the quote I received says the IRS will allow annual contributions up to about 3.5% of policy face for 7 years. (This is called 7-pay because you fully fund your policy in 7 years.)
In this calculation, we bumped up the Max Borrow amount to 90% due to the larger CashValue:PolicyFace ratio.We see the 100K VUL funded at 7-pay limits catches up to a taxable portfolio after 30 years versus never at the target premiums.
250K VUL -- 7-pay
Break even at 17 years.
500K VUL -- 7-pay
Getting rid of the sales load has brought break even point to about 6.5 years. Sounds like a viable option -- assuming:
- you max out all traditional retirement vehicles 401Ks, IRAs, HSAs, etc.
- you have a portfolio of tax-efficient investments in taxable
- you have a big emergency fund to avoid tapping into the policy early (surrender charges + losing the tax benefits)
- you will have plenty of money in retirement so you can keep the policy in force
- you don't need to tap all the money and will leave ~20% of the policy's cash value as death benefit for your heirs
Final Words
Remember all numbers and projections I showed here are mere samples. Don't come away from these articles with the idea that X is always better than Y. It will always be up to you to do due diligence on your own situation and options. Research, analysis and critical thinking -- use your brain and it will be your most important tool to evaluate investments. Download and have at it.
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