Should Clients Buy Life Insurance
in Defined Benefit (including 412(e)3) Plans?
Answer the following question by choosing which investment you or your clients would purchase. Assume you invest $100,000 and let it grow for 20 years. At the end of 20 years investment A and B have the following balances:
Investment A: $200,000
Investment B: $300,000
Of course the answer is B. Why? Because both investments cost the same amount and after 20 years, B was worth $100,000 more. The decision is a no brainer.
Read the rest of the newsletter with the understanding that I am discussing what is appropriate when helping a small to medium sized business owners who are looking for large deductions into a qualified plan for themselves.
Purchasing Life Insurance in a Qualified Plan
If you have a life insurance license, the chances are significant that you have been solicited by a major insurance company, IMO, FMO, GA, etc. to have you pitch profitable small business owners 412(e)3 defined benefit plan funded 50% with life insurance. If you are a CPA/accountant/EA, attorney, financial planner, the chances are significant that one of your clients has or will be pitched a 412(e)3 DB plan funded 50% with life insurance.
What is a 412(e)3 DB Plan? It is a qualified retirement plan that, by law, has to be funded with life insurance or annuity contracts. With a 412(e)3 DB (or non-412(e)3 DB plan), the EMPLOYER is funding the retirement plan to provide a specific retirement benefit for the employees at a specific retirement age. The retirement benefit is based on assumed growth rates on the money invested in the plan. The lower the assumed rate of return on the investment when the plan is setup, the more the employer must contribute to be able to provide the guaranteed retirement income for employees. Therefore, most advisors will use a very low assumed rate of return on the investments 2-3% to ďjack-upĒ the deduction. Also, the closer a client is to retirement, the more money needs to be contributed to the plan.
How is a 412(e)3 plan different from a 401(k)/PSP? With a 401(k)/PSP, money from the employer and/or employee goes into the plan where it is allowed to grow to any level (no restriction on growth) and can be used for retirement purposes by vested employees. So, if a 401(k)/PSP was funded for employee X and the account value of his/her money grew at 12% a year, the employees would vest and be able to use ALL of that money in retirement. With a 412(e)3 DB plan, if the returns on investments in the plan exceed the assumed rate of return, the future contributions of the employer would be lessened and the guaranteed retirement income would not change.
Why do clients use 412(e)3 plans? Because with the right demographics of a small business, 412(e)3 plans allow for the largest corporate deduction into a qualified plan for the owner(s).
Why does life insurance (LI) help create a larger deduction? The simple answer is because a LI policy is NOT a good investment (insurance loads) and by funding 50% of the annual contributions into a life insurance policy (vs. annuities), the assumed rates of return are driven down and therefore, the required contributions are driven up.
Letís get back to the initial question. ďWould you or your clients rather buy investment A or BĒ? The answer is B and you donít even have to think about it.
The following is a typical saleís pitch of a 412(e)3 DB with LIFE INSURANCE to a mythical Dr. Smith age 55, who makes $700,000 a year and is looking for the largest possible qualified plan contribution. Assume Dr. Smith has a $3,000,000 life insurance policy in an irrevocable life insurance trust (ILIT).
Advisor: Dr. Smith, as we have discussed, you can deduct this year through your business the following amounts depending on the various plans.
|Regular DB Plan
|412(e)3 DB Plan
|412(e)3 DP Plan with 50% life insurance
Dr. Smith: Wow, I like the $324,000 contribution plan. Thatís the best one for me isnít it?
Advisor: Yes, the 412(e)3 plan funded with 50% life insurance is the best plan to receive the largest deduction.
Dr. Smith: Great, letís implement that plan.
What was wrong with the saleís pitch (understanding that it is much abbreviated for this newsletter)? The advisor did NOT talk about the retirement benefit.
What if the advisor would have said the following:
Advisor: Dr. Smith, I want you to know that whether you fund a regular DB plan, 412(e)3 DB plan, or 412(e)3 plan funded with life insurance, your retirement benefit will be the same.
Dr. Smith: I donít understand; I would be contributing $166,000 more into the last plan listed than the regular DB plan. Why donít I receive more money in retirement?
Advisor: The plan is regulated and has a maximum limit for how much you can accumulate in the plan for retirement. No matter how much you put into the plan, your retirement benefit will be the same.
Advisor: So, Dr. Smith, which one of these plans would you like to use to receive your maximum retirement benefit?
Dr. Smith: I think I will go with the regular defined benefit. I know the contribution is less, but the retirement benefit will be the same and I can use the other money not contributed to benefit myself in other ways.
Dr. Smith: Advisor, can you help me find more deductions through my company as I now have an extra $166,000 to deduct if you can find plans that will benefit me?
What am I trying to get across with the above? Iím trying to illustrate that most advisors sell 412(e)3 plans incorrectly and that nearly ALL insurance companies pushing this concept educate advisors incorrectly. The plan is sold on the deduction NOT on the retirement benefit. Why? The honest answer is because an advisor wants the large deduction and really wants 50% of the contributions to flow into a life insurance policy because the commissions will be maximized.
Isnít there a place for selling life insurance in a 412(e)3 plan or any qualified plan for that matter? This is the million dollar question I get from most life insurance agents. The answer is yes. It is appropriate to buy life insurance in a qualified plan IF the client does not have an estate-tax problem. Why? When buying life insurance in a qualified plan for someone with an estate-tax problem you are nearly guaranteeing the death benefit will be estate-taxed. When an employee dies while a life policy is in a qualified plan (assuming an estate-tax problem), the death benefit from the qualified plan will be estate taxed.
Are there other problems with purchasing life insurance in a qualified plan? Sure, when the client wants to retire, what do you do with the policy? It can NOT be rolled over to an IRA. The life policy could be distributed to the employee and then gifted to an ILIT or an ILIT could buy the policy from the qualified plan, but doing so requires a lot of planning and is very expensive.
How should advisors sell 412(e)3 plans? Advisors should sell 412(e)3 plans on the retirement benefit not the deduction.
Roccy DeFrancesco, J.D., CWPPô, CAPPô, or CMPô
Founder, The Wealth Preservation Institute
Co-Founder, The Asset Protection Society
3260 S. Lakeshore Dr.
St. Joseph, MI 49085
Author of The Doctor's Wealth Preservation Guide; The Home Equity Management Guidebook: How to Achieve Maximum Wealth with Maximum Security; The Home Equity Acceleration Plan; and Retiring Without Risk; Bad Advisors: How to Identify Them; How to Avoid Them.
Circular 230 disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.