FIAs in ERISA Governed Pension Plans—21-Page White Paper
I am a huge advocate of using FIAs in pension plans. To download my 21-page white paper, click on the following link:
Why Buying Life Insurance in a Qualified Plan is a Terrible Idea!
Answer the following question: if your clients could invest $100,000 and let it grow for 20 years where at the end of 20 years the amounts equaled the following, which one should your clients purchase?
Investment A after 20 years = $200,000
Investment B after 20 years = $300,000
Of course, the answer is B. Why? Because both investments cost the same and after 20 years, B was worth $100,000 more. The decision is a no-brainer.
Answer the following question: If a business owner could take a deduction using life insurance in a qualified plan that is $150,000 a year vs. a plan with NO life insurance where the deduction is only $100,000 a year, which one would the affluent business owner choose?
Of course, the plan WITH life insurance as an investment because the deduction is larger.
Answer the following question: If the qualified plan with the $150,000 deduction generated the SAME RETIREMENT INCOME as the one with a $100,000 deduction, which plan should you as the advisor recommend?
The answer is the one with a $100,000 deduction.
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 a 412(e)3 defined benefit plan funded 50% with life insurance.
Why do clients use 412(e)3 defined benefit plans? Because with the right demographics of a small business, 412(e)3 plans allow for the largest corporate deduction into a plan for the owner(s).
Why does life insurance (LI) help create a larger deduction? The simple answer is that an LI policy inside a qualified plan is NOT a good investment. Further, 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.
Let’s get back to the initial question: Would you or your clients rather buy investment A or B? The answer is B and you don’t even have to think about it.
The following is a typical sales 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:
-401(k)/Profit Sharing Plan $50,000
-Regular DB Plan $158,000
-412(e)3 DB Plan $254,000
-412(e)3 DP Plan with 50% life insurance $324,000
Dr. Smith: Wow, I like the $324,000 contribution plan. That’s the best one, right?
Advisor: Yes, the 412(e)3 plan funded with 50% life insurance is the best plan to receive the largest deduction.
Dr. Smith: Great, let’s implement that plan.
What was wrong with the sales 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, a 412(e)3 DB plan, or a 412(e)3 plan funded with life insurance or not, your retirement benefit will be the same.
Dr. Smith: I don’t understand; I would be contributing $166,000 more in the 412(e)3 plan vs. the regular DB plan. Why don’t 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? I’m 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.
Isn’t 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.
Anything else? Yes, the client has to recapture as phantom income the Table I costs of insurance.
How should advisors sell 412(e)3 plans?
In my opinion, advisors should NEVER recommend a 412(e)3 plan. These plans force you to use only life or annuities as investments. If you want to use annuities in pension plans, simply use a traditional Defined Benefit Plan (or Cash Balance Plan) which allows for the purchase of annuities and life insurance (but it’s not mandatory).