What if I were to tell you about a significant tax deduction for most of the services you're already going to need in retirement? asks wealth manager Todd Rustman, citing a laundry list including medical care, dental care, disability, psychiatric care, home care, long-term care (LTC), prescription medication and over-the-counter drugs.
The question is not rhetorical, Rustman adds. Employers--particularly those with a low overhead and a cash-rich operation--will definitely be interested in hearing about little known 419(e) plans--the single-employer welfare benefit plan that qualifies under paragraph (e) of Internal Revenue Code section 419.
Rustman, president of GR Capital Asset Management LLC in Newport Beach, Calif., asserts that--used properly--this IRS provision should allow many such clients to sock away pre-tax funds for future disability and long-term care (LTC) insurance needs, and simultaneously, to secure life insurance and estate tax protection to boot.
The majority of Rustman's clients are under age 50 and head up their own successful companies. When they retire, many will need LTC benefits not covered by Medicare or other basic insurance plans. In fact, "A 65- year-old couple retiring today will need about $200,000 to cover health costs not covered by Medicare over the remainder of their lives," says Rustman, pointing out that Medicare does not pay for drugs, dental services or LTC expenses, and that that the average nursing home cost in 2006 was $69,000 a year.
What to do?
Rustman suggests that certain clients contribute to a 419(e) on behalf of themselves, their key employees, and other workers. When such contributions are directed properly as part of an appropriately funded trust account, employers can take a tax deduction for the contributions, have the funds grow tax-free, and also take them out tax-free in retirement. But Clients should not contemplate galloping off to the Galapagos, Rustman warns. Contributions to a 419(e)--which tend to be formidable--must be used for medical benefits such as those cited above.
Recently, Rustman prepared a proposal for a California urologist whose mentor died unexpectedly, leaving a burgeoning practice to his prot?g?. Rustman's 419(e) workup called for a total of $120,000 in annual pre-tax contributions to the plan from the urologist himself--$60,000 targeted as a premium that would fund the life insurance policy's death benefit, $36,000 to fund cash values that would go to pay long-term care costs, and $24,000 for cash values that would supply disability benefits--either through a self-funded program or via another health-related policy purchased in retirement.
The $120,000 contribution is based on the assumption that the urologist's compensation will soon reach $1.2 million annually. His wife, a nurse who is also a member of his staff, could sock away another tax-deductible $22,500 a year based on Rustman's calculations, while the remaining two lower-paid employees could invest $3,200 and $3,500 a year, respectively. Among several routes to take, these amounts might be invested in a universal life program earning an internal savings rate of 5.7 percent a year or in more aggressive instruments including equity indexed products. Ten years down the road, participants can take a tax-free loan to themselves on the policy in order to fund post-retirement medical costs.
Too good to be true?
While 419(e) programs may sound almost too good to be true, there are several complications to consider in addition to the limits on spending cited above. These include the fact that employers must hire third party administrators with actuarial expertise to create the trust in question and implement the programs. There are also discrimination testing requirements to consider, and offsets for owners and key employees who contribute to defined contribution plans as well as 419(e)s.
Moreover, life insurance is the vehicle typically used to secure the tax-free buildup cash values available to employers and qualified, participating retirees who have opted into such programs. And sophisticated investors' longstanding distrust of insurance companies and the instruments they sell is clearly one of the deterrents to creating such programs. Indeed, such programs need to be maintained over a period of at least a decade to function optimally, and to eliminate the problem of policy surrender costs and other complications for shorter term commitments.
But before abandoning the concept, you and your clients will want to consider what is at stake. Investment growth inside section 419(e) plans would normally be taxable to the employer. The reason life insurance makes such a good marriage partner for funding the 419(e) trust is that the policy values can grow tax-free.
"This creates a potential double benefit: If an employee dies early, then death benefits are paid to beneficiaries. But if the employee lives too long, the tax-deferred build-up of the life insurance policy is available to fund [medical] benefits," explains Jay Adkisson, partner with law firm Riser Adkisson LLP in Orange County, Calif..
"Typically, the medical benefit is funded with one or more insurance policies owned by the trust on the life of one or more owners, using cash values and accrued death benefits to cover medical expenses. This takes advantage of the tax-free buildup within the life insurance policy," Adkisson says. "On the other hand, the death benefit is funded with an insurance policy on the life of each participant, payable to the trust but then passed entirely to the participant's beneficiaries."
In addition to their deductibility, premium contributions to 419(e) plans are also flexible, and amounts can vary over time. On the other hand, Rustman warns, it is important to note that when the 419(e) plan pays a disability premium for a participant but does not report it as current income, the disability benefit will be viewed as taxable income--when and if the participant needs it.
Nevertheless, advisors see myriad benefits for the right client. For example, the Riser Adkisson Web site tutorial notes the "golden handcuff" effect: The employer enjoys a competitive advantage because the company can offer valuable benefits to reward valued employees at affordable costs; it can use these benefits to stem turnover of expensively trained and valuable employees. Moreover, companies looking to reward their most important employees--owners and executives-- are often limited in the amount that can be contributed to benefits, particularly retirement plans. As long as it is actuarially reasonable, a Welfare Benefit Plan can offer additional unlimited benefits--like family protection and retiree medical benefits for these employees
Moreover, post-retirement medical accounts are not vested and only become available for use by an employee when retirement age is reached while still an employee of the firm. Amounts forfeited due to termination of employment are retained by the plan.
"Planners need to know this thing is fantastic!" says CFP Ellen R. Siegel, president of Ellen R. Siegel and Associates of Miami, Fla. Siegel has used the strategy for a client who owns a computer software consultancy with his wife. "They have maxed out their defined benefit plan," Siegel notes, and as this client makes over $1 million a year on his own and another $250,000 with his wife's salary, the couple could afford to make a tax deductible 419(e) contribution of $190,000 a year. That contribution will secure life insurance to cover his wife and child as well as a daughter from a previous marriage if he dies young, and LTC coverage for the couple, should they live longer.
Siegel first learned of the 419(e) when she attended a presentation by a small insurance brokerage in Miami to earn a few extra continuing education credits. The speaker, she says, was "a very knowledgeable attorney from Prudential," but that didn't stop her from being wary of "yet another pitch for insurance that doesn't make sense" for anyone but the underwriter. Not in this case, she decided: "The more I'm hearing it the more I'm thinking, 'If this is true, it's just perfect for the right client.'"
Janet Aschkenasy (firstname.lastname@example.org) is a freelance writer and regular contributor to Wealth Manager.
Discrimination Testing and DC Offsets
Advisors interested in exploring these plans for clients should consider the following qualifications:
K Discrimination testing: In order for a 419(e) plan to be deemed non-discriminatory, employers must meet a 70 percent test just as they do with ERISA plans, observes David Neufeld, a tax attorney and partner at Integrity Financial Partners, a 419(e) plan TPA based in Iselin, N.J. "If 70 percent of participants are offered 419(e) benefits, 80 percent of that 70 percent have to participate to pass nondiscrimination testing laws," he says. That's one reason the program will be easier to implement for smaller businesses with fewer employees.
K Offsets: Every dollar that goes into a 419(e) plan for medical reimbursement funding for a company owner or "key employee" offsets the key employee's maximum IRC Section 415 limits for defined contribution plans, Neufeld adds. As an example, if the 415 limit is $45,000 for key employees, and an employer puts $10,000 away for that employee's 419(e) contribution. that employee's defined contribution would have to drop to a maximum $35,000. On the other hand, 419(e)s do not reduce anyone's defined benefit plan limits. Nor do they reduce defined contribution plan contributions for rank and file workers, he says.
"The risk," Neufeld cautions, "is when someone tries to use [419(e)s] in ways for which they were not intended, or when [marketers'] promises are too optimistic. Beware of funding numbers that are too high," he warns.
Still, Neufeld remains a fan: "If there's one message to take away from all of this, it's that when used appropriately and correctly, these plans are great," he says. "These are tremendously valuable and tremendously powerful programs that should be in everybody's portfolio."
Qs and As
Can an employer maintain both a 419e plan and a qualified retirement plan and make deductible contributions to both plans?
Yes, because each plan accomplishes its own separate purpose. One provides life insurance benefits, whereas the other provides for retirement. A 419(e) plan should not be considered as a replacement for a qualified plan, but rather as a separate plan which fulfills other needs. To the extent that a post-retirement medical benefit is included, the contributions to the plan must be aggregated and offset with existing plan limits of the qualified plan.
How safe are plan assets against claims of creditors?
The plan assets will not be subject to claims of creditors of any of the parties to the plan because neither the employer nor the participants has ownership of the funds. Additionally, under the terms of the plan, the employer has no right to have any of the assets revert to the business.
May contributions to a plan be flexible?
Yes, the contributions can vary; also, the employer retains the privilege of reducing or discontinuing contributions and amending the plan. Care must be taken to have enough funds in the plan to carry the insurance without the danger of lapsing. So long as there is enough funding to maintain the insurance contracts, then the annual contributions may be varied, but may not exceed the "qualified direct costs."
Source: Estate Planning Team, Palm Desert, California (www.myept.com)