401(k) contribution

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Jul 31, 2008 3:52 pm

I'm dealing with a young, wealthy couple.   They have a net worth of around $7,000,000.  They will inherit at least $15,000,000.   They have no debt and live very comfortably on $4,000/month.  $150,000 is gifted to them every year.   The grandparents have already funded education for their two children.

 
Pertaining to their 401(k) plans, should they max out their contribution, only contribute to the match, or contribute nothing?  What is your rationale?
 
I'll answer other questions if they are needed to answer mine.  Thanks.   I have my thoughts, but I was curious as to what others thought.
Jul 31, 2008 4:28 pm

Looking near-term, would the salary reduction benefit them any at tax time?

Jul 31, 2008 4:40 pm

My initial thought would be to contribute up to the match.  Any more than that, and you're giving up alot of control of the money.  What's the point of deferring at 35% if there is a good chance they'll be in a higher tax bracket in the future?  I have a few more questions though:

 

When's the last time they reviewed their wills and trusts? 
How much life insurance do the have?  What kind?  What is their take on term vs. permanent?
How much umbrella coverage do they have?
How much do they like to keep liquid? 
What is their opinion on legacy-building?  Besides their family, who do they want to have benefit after they're gone?
How do they feel about real estate?  Collectibles?

I'm not a big fan of 401k's outside the match.  Given they're so well off, they have so many more options to build wealth than most people.  Ultimately though, if the castle isn't protected by a deep and wide moat, how to build wealth won't matter.

Jul 31, 2008 4:40 pm

Adopt me and I will never work again Just having you on Anonymous...upcoming Long Weekend.

Jul 31, 2008 4:51 pm
anonymous:

I'm dealing with a young, wealthy couple.   They have a net worth of around $7,000,000.  They will inherit at least $15,000,000.   They have no debt and live very comfortably on $4,000/month.  $150,000 is gifted to them every year.   The grandparents have already funded education for their two children.

 
Pertaining to their 401(k) plans, should they max out their contribution, only contribute to the match, or contribute nothing?  What is your rationale?
 
I'll answer other questions if they are needed to answer mine.  Thanks.   I have my thoughts, but I was curious as to what others thought.



So they have you helping them with $15,000/year? Who is handling the real money?

Jul 31, 2008 5:06 pm

Do you have the grandparents?

If not, would you like to show them how to avoid uncle sam for the next 50 years?
Jul 31, 2008 5:32 pm
deekay:

I'm not a big fan of 401k's outside the match. 



 
Would you elaborate on this, please.
 
As with nearly every other topic in this industry, if I asked five Jonesers about how they would advise a particular client regarding contributing to their 401k, I'd get at least seven different opinions.
 
Is there no hard and fast rule?
Jul 31, 2008 6:36 pm
Borker Boy:
deekay:

I'm not a big fan of 401k's outside the match. 



 
Would you elaborate on this, please.
 
 
Sure.  There are three phases of money:  accumulation, distribution, and transfer.  401k's (especially with a match) are tremendous accumulation vehicles.  Pre-tax contributions and tax-deferred growth help someone grow their money quickly.  However, 401ks are horrible vehicles to take money out of, and one of the worst to transfer to other generations.  The government is in complete control of the tax code, and they know they've got huge amounts of deferred taxes due to them.  Who's to say they won't jack the highest marginal tax rate to 60%?  Or 90%?  Plus, the gov't can put an excise tax on large balances, change the minimum age of withdrawal, and in general, monkey with the tax code to their advantage.
 
An analogy I sometimes use with my clients is this:  "Imagine I pulled you off the street and asked you to go into business with me.  Here is the way it's gonna work - you'll put up all the money and take all the risk.  Because you're doing that, I'll draw up all the documents.  However, I have the right to change the docs whenever I feel like it.  Right now, I'll only be a 30% partner, but can change how much of a cut I take, and there's nothing you can do about it.  You have to stay in the partnership until you are at least 59 1/2.  If you decide to leave early, I'll take my cut plus another 10% for my time. 
 
Do you go into business with me?"
 
Once they see that the 401k isn't all it's cracked up to be, they're begging me for answers. 
Jul 31, 2008 8:01 pm

Borker Boy,

 
Give me your best educated guess on this question.  Let's assume that the 401(k) money for my clients grows to $1,000,000 at their death and their total net worth is $20,000,000+.  Their children are the beneficiaries of the 401(k) money.  What is the total taxation of this 401(k) money?  (Just give a quick rough guesstimate.)
Jul 31, 2008 8:20 pm

$350-$400K

Jul 31, 2008 8:56 pm

75% - likely more in the future. 


If they are charitably inclined, contributing up to the match and naming charities as the beneficiary would be my choice.  If they aren't, then I'd counsel them not to contribute.
Jul 31, 2008 10:48 pm

With that much NQ funds already, and more to come, I would max the 401K. It will end up being "never money" and pass on to their kids tax free and possibly "stretched" (if the kids manage it right). That way, much of their income is sheltered (Idue to the 401K contributions), and you have flexibility in how you manage the rest of the NQ portfolio (it sounds like muni's and growth stocks will keep their tax bill low and keep growing).

Aug 1, 2008 8:27 am
B24:

With that much NQ funds already, and more to come, I would max the 401K. It will end up being "never money" and pass on to their kids tax free and possibly "stretched" (if the kids manage it right). That way, much of their income is sheltered (Idue to the 401K contributions), and you have flexibility in how you manage the rest of the NQ portfolio (it sounds like muni's and growth stocks will keep their tax bill low and keep growing).

 
Explain to us your rationale of putting "never money" in a vehicle that is terrible at distributing and transferring assets.  What happens if the couple needs/wants the 401k money in the future?  They defer today at 35%, but what will tax rates be in the future?  I'm not trying to predict the future, but there is a good chance they'll be in a higher tax bracket in the future.
Aug 1, 2008 8:38 am

DK, I understand your point.  However, 401K's are not bad wealth transfer options if done correctly, and it is one place where he can shelter some income.  Now, if the heirs pull it all out day 1, then yes, it was a bad option.  But with stretch options available, it can really defer taxes for 2 generations.  If the amount of money he had inherited was not so large, and was in qualified accounts, I would say yes, he needs to keep more outside of his 401K.  But I think he's got so much NQ money that why not get some "tax diversification" but pumping up his 401K and deferring a lot of those taxes.  Either way you aer sort of gambling on tax rates, future events in the family that are not yet known, what the clients will do with their money, etc.  I just think spreading it among taxable and tax deferred accounts is wise.  But only putting 3 or 4% per year into the 401K seems rather meager compared to his overall wealth.  But generally speaking, I think you could arrange his investments either way and come out just fine.

 
One other thing - if you put it into the 401K, you have more freedom as far as the type of assets you use.  You do not have to be concerned about dividend paying funds, bond interest, etc., as it is tax deferred.  With the taxable money, you have to be a little more particular about the investment classes you use in order to keep taxes down.  With that amount of money (I think all-in, he said it will be over $20mm??), you could be looking at losing a large chunk of your gains to taxes.
 
Again, without knowing their real intentions, you can't come to a finite conclusion.  There are some great ways to arrange trusts if they are charitable that will help with taxes.
Aug 1, 2008 10:18 am

Not dealing with the specifics of taxation and distributions as the laws are different in the U.S. versus Canada. With a client/s in your described situation I would strongly suggest bringing in both the expertise of both lawyers and accountants. Does your firm provide access to these professionals for clients?

If so, I would be thinking of that as a way to provide a complete analaysis for your client/s.
Aug 1, 2008 10:53 am
deekay:
Borker Boy:
deekay:

I'm not a big fan of 401k's outside the match.







Would you elaborate on this, please.



Sure. There are three phases of money: accumulation, distribution, and transfer. 401k's (especially with a match) are tremendous accumulation vehicles. Pre-tax contributions and tax-deferred growth help someone grow their money quickly. However, 401ks are horrible vehicles to take money out of, and one of the worst to transfer to other generations. The government is in complete control of the tax code, and they know they've got huge amounts of deferred taxes due to them. Who's to say they won't jack the highest marginal tax rate to 60%? Or 90%? Plus, the gov't can put an excise tax on large balances, change the minimum age of withdrawal, and in general, monkey with the tax code to their advantage.



An analogy I sometimes use with my clients is this: "Imagine I pulled you off the street and asked you to go into business with me. Here is the way it's gonna work - you'll put up all the money and take all the risk. Because you're doing that, I'll draw up all the documents. However, I have the right to change the docs whenever I feel like it. Right now, I'll only be a 30% partner, but can change how much of a cut I take, and there's nothing you can do about it. You have to stay in the partnership until you are at least 59 1/2. If you decide to leave early, I'll take my cut plus another 10% for my time.



Do you go into business with me?"



Once they see that the 401k isn't all it's cracked up to be, they're begging me for answers.





Deekay-

They could just opt to do the ROTH 15,000 year and not worry about the future tax consequence.. (Obviously, legislation could change that rule too) but still it's a good option for these types of clients. The rest could go into an annuity..



Miss J

Aug 1, 2008 11:18 am
Give me your best educated guess on this question.  Let's assume that the 401(k) money for my clients grows to $1,000,000 at their death and their total net worth is $20,000,000+.  Their children are the beneficiaries of the 401(k) money.  What is the total taxation of this 401(k) money?  (Just give a quick rough guesstimate.)
 
Ladies and Gentleman, we are very possibly looking at taxation of over 100%.  My quick calcualtion, assuming that the beneficiary doesn't stretch the money will be that the tax on this $1,000,000 will be about $1,100,000.  (If they stretch it, and it grows, they'll get more than $1,000,000, but they will also pay more than $1,100,000 in taxes.) 
 
Does anyone know why this is correct or care to tell me why I'm wrong?
Aug 1, 2008 11:19 am
B24:

DK, I understand your point.  However, 401K's are not bad wealth transfer options if done correctly, and it is one place where he can shelter some income.  Now, if the heirs pull it all out day 1, then yes, it was a bad option.  But with stretch options available, it can really defer taxes for 2 generations.

 
What's the point of building wealth if you or future generations can't enjoy it?  When you stretch the QP, all you're doing is deferring taxes, not avoiding them.  At some point, they will be due.
 
  If the amount of money he had inherited was not so large, and was in qualified accounts, I would say yes, he needs to keep more outside of his 401K.  But I think he's got so much NQ money that why not get some "tax diversification" but pumping up his 401K and deferring a lot of those taxes.  Either way you aer sort of gambling on tax rates, future events in the family that are not yet known, what the clients will do with their money, etc.  I just think spreading it among taxable and tax deferred accounts is wise.  But only putting 3 or 4% per year into the 401K seems rather meager compared to his overall wealth.  But generally speaking, I think you could arrange his investments either way and come out just fine.
 
I see what you are getting at.  You are correct:  none of us know what taxes will be in the future.  All things being equal, if you had a choice between maintaining control and not maintaining control over my money, I'll keep control.  You lose access in a 401k until you're 59 1/2.  The government has the power to change the rules at any time.  You are limited to the investment choices offered.  Unless you yourself are the rep on the 401k, you legally cannot give advice on the specific offerings. 
 
One other thing - if you put it into the 401K, you have more freedom as far as the type of assets you use.  You do not have to be concerned about dividend paying funds, bond interest, etc., as it is tax deferred.  With the taxable money, you have to be a little more particular about the investment classes you use in order to keep taxes down.  With that amount of money (I think all-in, he said it will be over $20mm??), you could be looking at losing a large chunk of your gains to taxes.
 
Again, without knowing their real intentions, you can't come to a finite conclusion.  There are some great ways to arrange trusts if they are charitable that will help with taxes.
 
I'm assuming you are referring to CRTs.  By themselves, the donor loses all control, but gets a tax credit.  However, the legacy suffers.  My clients would rather have the biggest estate available to them net of taxes.
 
Ultimately, there is more that needs to be addressed.  All-in-all, there are other more efficient ways these folks can invest for the future than a 401k.  I'm not saying that 401ks are bad.  However, if you're investing in them just to lower taxes today, you're setting yourself up for a rude awakening.  If taxes stay the same when they withdraw money, there will be no tax savings.  If taxes are higher when they retire, they lose.  Yes, if taxes are lower when they retire, they win.  We are at the lowest income tax rate in history (other than when the income tax was originally set up).  What are the chances they'll be lower in the future?  I would argue slim to none. 
Aug 1, 2008 11:24 am
MISS JONES:
deekay:
Borker Boy:
deekay:

I'm not a big fan of 401k's outside the match. 





 

Would you elaborate on this, please.

 
 

Sure.  There are three phases of money:  accumulation, distribution, and transfer.  401k's (especially with a match) are tremendous accumulation vehicles.  Pre-tax contributions and tax-deferred growth help someone grow their money quickly.  However, 401ks are horrible vehicles to take money out of, and one of the worst to transfer to other generations.  The government is in complete control of the tax code, and they know they've got huge amounts of deferred taxes due to them.  Who's to say they won't jack the highest marginal tax rate to 60%?  Or 90%?  Plus, the gov't can put an excise tax on large balances, change the minimum age of withdrawal, and in general, monkey with the tax code to their advantage.

 

An analogy I sometimes use with my clients is this:  "Imagine I pulled you off the street and asked you to go into business with me.  Here is the way it's gonna work - you'll put up all the money and take all the risk.  Because you're doing that, I'll draw up all the documents.  However, I have the right to change the docs whenever I feel like it.  Right now, I'll only be a 30% partner, but can change how much of a cut I take, and there's nothing you can do about it.  You have to stay in the partnership until you are at least 59 1/2.  If you decide to leave early, I'll take my cut plus another 10% for my time. 

 

Do you go into business with me?"

 

Once they see that the 401k isn't all it's cracked up to be, they're begging me for answers. 



Deekay-
They could just opt to do the ROTH 15,000 year and not worry about the future tax consequence.. (Obviously, legislation could change that rule too) but still it's a good option for these types of clients. The rest could go into an annuity..

Miss J

 
Do we know a Roth 401k is available?  How is an annuity appropriate as well (not bashing or condoning it, I'm trying to understand your train of thought.)?
Aug 1, 2008 12:31 pm

They don't have Roth Options.  Both have access to 401(k)'s.