The media does a solid job of reminding the 78 million baby boomers1 that many of them are unprepared for their retirement years. Boomers are still recovering from a turbulent decade in the financial markets that saw eroding equity in their homes, lost jobs, set backs in retirement and investment accounts, and high levels of personal debt. A good portion of those unprepared for retirement will face difficult decisions about outliving their money, continuing to work if they are able, or changing their lifestyle.
Approximately 7 million boomers are entrepreneurs2 who have built successful businesses. They, too, face the same challenges in later years, but they have more ways to address them. This article will focus on an employee benefit plan available to certain types of business owners that can help provide life insurance for employees and a potential source of assets that could serve as a retirement income planning solution for this group.
Before going further, let’s note the material differences between retirement planning and retirement income planning. Retirement planning is simply accumulating enough wealth for a client’s retirement years. Retirement income planning is the process of taking that wealth and turning it into an income stream that your clients can ideally live on for the rest of their lives. Those looking to discuss their retirement plans with a financial advisor may want to get in touch with the likes of WealthVisory Private Clients to try and find out what the best path forward is for their personal circumstances as there are many options and trying to sort through them all without the help of an expert can be difficult.
Unfortunately, some may never accumulate enough. Those who do may still outlive their money if they don’t plan correctly. The risks in retirement income planning are typically as follows:
• Longevity. We are living longer and more active lives.3
• Market risk. Fluctuations in assets tied to the market can have adverse effects, particularly when taking distributions.
• Inflation. The cost of living (outside health care) continues to rise.
• Health care. On its own, health care costs have skyrocketed over the years. This will increase in cost as people approach their final years.4
• Point in time. If a retiree’s portfolio has been greatly reduced by market losses, continued withdrawals reduce the size of the portfolio, making it increasingly unlikely that the losses can be recovered.
• Taxes. While we currently enjoy lower income tax rates, Social Security may be partially taxable depending on the source of a retiree’s income. Withdrawals from retirement plans are taxable.
• Withdrawal rate. An old industry rule of thumb was that a 5 percent annual withdrawal rate (taking annual distributions equal to 5 percent of the portfolio’s value) would allow an investor to live off his portfolio without depleting it. Current studies show that a more realistic “safety withdrawal rate” should not exceed 3 to 4 percent.5
It’s important to note that women have greater challenges in retirement income planning. They live longer, which requires more savings. They typically make less than their male counterparts. Their health care is more expensive. Combine all these factors and you see why women need more money in retirement years.6
Now let’s look at business owners. This highly sought after group is attractive to advisors due to the many alternatives and products available to them and the vast wealth they represent. Most have already considered, if not established, qualified plans. Some have even combined multiple plans to maximize contributions.
There are more alternatives than before to prepare business owners for their future and lower their taxes. One employee benefit plan in particular (Section 79) is enjoying increased attention by business owners and advisors as either a supplement to retirement plans, or even as an alternative. This plan not only provides free group term life insurance to employees (helping with employee retention), it can also provide a business owner with tax deductions, the ability to accumulate cash value on a tax-deferred basis, and the potential to access that cash value later through tax-free policy loans and withdrawals.
Keep in mind that a policy loan or withdrawal from a cash value life insurance policy will reduce the cash value and death benefit and may result in a taxable event. With-
drawals up to the basis paid into a contract and loans thereafter will not create an immediate taxable event, but substantial tax ramifications could result if a contract lapses or is surrendered. Surrender charges may reduce the policy’s cash value in early years.
Some of the key features of a Section 79 plan are as follows.
• Part of the IRS tax code, Section 79 allows a business to offer group term life insurance to employees as a fringe benefit. It also allows for permanent benefits to be provided, which allows the plan to be funded with individually owned cash value life insurance.
• Section 79 plans can be offered in addition to a qualified plan.
• Premium contributions are fully deductible for a business.
• When cash value life insurance is elected, an employee includes only a portion of each premium in income.
• Life insurance premiums aren’t subject to the same contribution limits that apply to qualified retirement plans, but rather are based on the amount of death benefit applied for and other underwriting criteria. This may make a Section 79 plan with permanent life insurance more attractive to business owners who have maxed out the amount they can contribute to qualified plans. However, reasonable compensation limits do apply to Section 79 plans.
• Assets are removed from the reach of company creditors.
• When electing a permanent benefit policy, a plan can be designed to have a high premium for a given death benefit in order to maximize the potential for cash buildup in the policy, which grows tax-deferred.
• Cash can be accessed in the form of tax-free policy loans and withdrawals. With proper design and sufficient funding and time to accumulate cash value, there may be the possibility of taking income 20 or more years. Some policies also offer riders that can help prevent the risk of policy lapse or enhance the income available. Riders are optional, may be available at additional cost, and may not be available in all states or on all products.
• Life insurance pays a tax-free death benefit to beneficiaries.
Section 79 plans appeal to business owners who generate stable cash flow, have a need for life insurance or to provide life insurance to their employees, and are looking to supplement their current retirement programs. Note that a business must either be structured as or have access to a C corporation.
Section 79 also addresses many of the challenges of retirement income planning. How? Consider the following:
• Contributions result in lower taxes for the business, allowing the owner(s) to keep more of their profits.
• Loans and withdrawals against a policy’s cash value can also be taken tax free (as long as that policy stays in force) and used for retirement income. This may compare favorably against qualified plans where distributions are taxable and may have higher costs to a business to provide for its employees. This is one of the most appealing features of a Section 79 plan.
• Since a Section 79 plan is not a qualified plan, there are no tax penalties if cash withdrawals are made before 591/2 years old. However, policy surrender charges may reduce the policy’s cash value in early years.
• Many policies offer optional accelerated benefit riders at no additional cost, which allows an owner to access portions of the death benefit in the event of a terminal, chronic or critical illness. It’s important to realize that these riders are not long term care insurance, although the chronic illness riders often use similar criteria as long term care insurance to qualify for benefits. These riders reduce the death benefit, cash value and loan value for those policies with such values.
Who Are the Best Candidates for Section 79 Plans?
These plans may be a great alternative for business owners who have “maxed out” their current retirement plans. These plans also call for a five-year commitment. Owners must be employees and insurable; otherwise, the strategy doesn’t work. A business owner should have access to other liquid funds and should avoid “dipping into” this policy for at least 10 years in order to truly benefit from the plan. The time factor makes the Section 79 plan very appealing to younger business owners.
The context in which this article is written is greatly focused on how Section 79 plans benefit the baby boomer generation. However, there are other nuances and applications for this little known strategy. The potential access to cash value through tax-free loans and withdrawals on an annual basis, the opportunity for a business owner to reduce taxes, the optional accelerated benefit riders that give the owner the ability to use the product to pay for certain health care costs that come later in life are valuable propositions. Further, a number of policies offer minimum guaranteed interest rates on the cash value accumulation. These guarantees are dependent on the claims paying ability of the issuing companies.
A Section 79 plan, like all strategies, has its limitations yet remains useful to the right audience. Take some time to learn more about it, see how it can help your clients, and watch how it can grow your business.
For Agent Use Only-Not For Use With The Public.
Footnotes:
1. U.S. Census Bureau, July 1, 2008.
2. ”Statistics: Number of Baby Boomers, Baby Boomer Business Owners, and Potential ESOP Universe,” Aaron Juckett, 3/2/2008.
3. Annuity 2000 Mortality Table, Society of Actuaries Committee on Life Insurance Research.
4. ”Funding Savings Needed for Health Expenses for Persons Eligible for Medicare,” Fronstin, Salisbury, VanDerhe, Employee Benefit Research Institute, December 2010, www.ebri.org/pdf/briefspdf/EBRI_IB_12-2010_No351_Savings1.pdf.
5. Fidelity Retirement Income White Paper, 2011.
6. ”Women and Investing: What Every Boomer Woman Needs To Know About Planning For Retirement,” Oppenheimer Funds, Inc., 2007.
