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What would you do? Here's my situation:

Me = 38, wife = 33. Both working, combined gross income about $140K/yr. One child - 10 months old.

We just recently starting thinking about planning for retirement. Our main financial goal: saving enough so that I can retire at age 62 (60 would be better) and my wife can retire when I do (she would be 57) with about 75-80% of our current income (at least). We are both contributing 6% of our salary to our 401ks (our company matches up to 6%). We now want to step up our retirement savings.>>

If you want 75 to 80 percent replacement ratio you are kidding your self - there is no way 6% of your pay will get you there - do the math - you should be thinking more like 15% and using 80% equity protfolio allocation

<<I'm assuming that the best way we should do that is to increase our 401k contributions. We have Vanguard's S&P 500 index as one of our investment options as well as company stock (we work for IBM), a small cap index fund, among others.>>

Keep in mind that asset allocation and time are the keys to long term portfolio returns. IBM is a good stock but what percentage of your retirement portfolio and if you include your income what happens to you dependence on this single company returm. The Vanguard S&P Index is a good starting point - what is your international allocation look like - have you combined your wifes protfolio allocaiton with your along with non-retirement assets?

<<A former co-worker who is now a "financial planner" is pushing us hard toward a variable universal life policy that he sells instead. He says that we need to "diversify" - that since we will pay taxes on 401k distributions, we need to be investing in the VUL policy instead of increasing our 401k contributions since we can take money out tax-free during retirement.>>

Ok great - but this alone is not justificatio for purchasing a life insurance policy.

<< I should mention that we do need more life insurance. We are currently underinsured and are looking to add about $300-500K on each of us. >>

Great now you have a reason to talk about more life insurance. Key in the eveluation of live insurance is need and length of the need. If you need life insurance for less than 7 years buy term. If you need if for more than 7 years it is time to own your insurance. The issue is 'amount of coverage at risk" - if you do not understand this statement and you think buy term and invest the difference is the answer then - you don't know what you don't know - maybe you should reconsider jumping into a merky pond without knowing where the stumps are. You may find yourself with a broken neck!

<<From everything I've read over the last few weeks (here as well as other sites and many books), it seems like we should max out our pre-tax 401k contributions before we consider other retirement investments. I'm not concerned about liquidity - I don't plan to touch the money before retirement (I can always borrow against the 401k). We are approaching the income limit for a Roth IRA (will surpass it next year) so that doesn't look like an option.>>

It is good that you are not concerned about liquidity but what about disability? Many variable whole life policies have allow you to purchase "waiver of premium" which will make the full premium (insurance expense and side fund investment contribution) in the event you become disabled. What would be the impact on you buy term and invest the difference in the event you were to become disabled?

<<If I'm thinking right, we would be better off investing before-tax dollars and paying taxes when we withdraw in retirement rather than investing after-tax dollars to withdraw tax-free. I mean, if we are in the 31% tax bracket, that means that for every $100 we can contribute to our 401k, we could invest $69 in a VUL policy. Over the 20+ years of tax-deferred compounding, it would seem like the 401k investment would grow much faster (assuming equal rates of return, which would be giving the VUL a break considering all of the fees) so that we would be much better off investing the extra money in the 401k. It seems like we would have enough extra money to offset the fact that we would then have to pay income tax on withdrawals. Hmmm... maybe I can find an on-line calculator to help figure it out.>>

There is a great deal of truth to this logic - though you should think about the disability issue and the fact that loan represent non-taxed withdrawals - death benefits payoff loans and the balance is paid tax free.

The last consideration is the issue of estate taxes - when you build this large pool of money if you don't spend it you may pay 70% in taxes if it is left in a qualified plan when you die.

<<There are a lot of fees on this VUL policy that seem very high - like the 6% premium charge. That means that in the above example I would have to take another 6% off of the $69 before it goes into the VUL policy! The 401k management fees are very small by comparison. I also don't like the VERY HARD sales pitch I am getting for the VUL policy.>>

The sales load can be large in the early years - but if you are to view this as a 15 or 20 year investment / insurance purchase they are minimized greatly

<<To me it seems like we should just buy some term insurance and increase our 401k contributions. It seems that maybe a small, overfunded VUL policy MIGHT be an option after we have maxed out all our pre-tax 401k contributions. Am I right? What would YOU do? >>

Again consider the disability issue - and the fact that you need in excess of 15% to reach the defined income replacement ratio - I do not think the VUL the proper product - rather a whole life variable product.
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