Authors: Mark Rooney, CFP®, ChFC, CLU, Founder and Managing Partner and Jamie C. Smith, JD, Managing Partner, The Business Strategies Group of Southern California
· There are 5.8 million small businesses (less than 100 employees) in the United States alone.
· Small businesses represent 98% of the private (non-governmental/non-profit) entities in the country.
· Small businesses employ 42 million people, which is 47.5% of the private sector workforce.
· 63% of the new jobs in America over the past two decades were created by small businesses.
· 51% of business owners are over age 50 and only 16% are under age 35.[1]
Business owners, executives and key employees must juggle many balls and have knowledge in various and diverse areas that do not directly relate to the nature of their business. One common concern is accumulating funds for retirement, particularly in a tax-advantaged manner.
Company retirement plan such as 401(k), defined contribution, profit-sharing, simplified employee pension (SEP), and more are attractive approaches. A properly constructed and government approved plan can make retirement contributions tax-deductible and allow potential earnings to grow tax deferred. Taxes are levied only when money is distributed from the plan, either in a lump-sum or structured as income.
While these retirement plans can provide greater accumulation and distribution possibilities than purely “saving or investing“ on your own, the plans must “qualify” for the tax benefits by adhering to important regulations of the IRS, the Department of Labor (DOL) and the Employee Retirement Income Security Act (ERISA).
Some of the rules include, but are not limited to…
· Non-discrimination provisions
· Vesting (account ownership) requirements
· Required timing of distributions
· Access to funds without penalty
· Flexibility of contributions
· Administration, reporting and audit requirements
· Investment and savings options
· Employee education
· Expected benchmarking
…and many more.
When properly designed and administered, these “QUALIFIED” plans are considered a tremendous tool to develop retirement income and an important tax preference provided by the government to encourage retirement self-reliance.
The challenge to many owners, executives and highly compensated employees is that the allowable contributions vary by plan type and are limited by regulation.
This commonly creates a scenario where an employee compensated at $60,000 a year can retire on 100% of their pay, while the ownerreceiving $400,000 per year may retire on only 39% of their previous income.
Take the $60,000 earner who works at the company for 30 years and contributes 10% of their income to the company retirement plan. Combine those contributions with moderate earnings in the plan and their annual retirement income from the plan could approximate $2,800 per month. Add that to approximately $2,200 per month from Social Security, and you have $5,000 per month (or $60,000 per year). That is 100%!
The $400,000 per year owner/executive will get roughly $3,000 per month from Social Security and approximately $10,000 per month from their company plan, all variables being equal. Thus, the higher paid person has $156,000 per year in retirement income. That is only 39%!
This occurs because the amount of money the higher paid person can contribute to the plan is “CAPPED“ by regulation at an average of $20,000 per year. This involves both hard-dollar limitations and caps on the amount that is considered “eligible” income for contributions to the plan.
Table 1: Hypothetical Retirement Income Example (Employee vs. Owner/Executive)
IS THIS FAIR??? According to the regulations that apply to “Qualified Plans” it is!
ANOTHER (OR ADDITIONAL) APPROACH
Section 7702 of the Internal Revenue Code creates a way to accumulate earnings on a tax-deferred basis and distribute lump sums or structured incomes on a tax-free basis. This creates a highly similar result to a qualified plan, but is not subject to the same requirements, rules and restrictions.
The plan can be highly selective (versus non-discriminatory) and it is virtually uncapped. Many have likened it to an unlimited “Roth“ plan. Used properly, it can make up the difference between 39% (or whatever your number is) and 100%.
Section 7702 of the IRS code governs how much money can be accumulated inside a life insurance policy without being currently taxed (tax-deferred). It also indicates how, properly designed and administered, those accumulated funds can be distributed on a non-taxed, non-reportable basis. Thus, a 7702 plan can provide comparable benefits to a qualified plan in terms of accumulation, distribution and even investment flexibility, but on an entirely selective and uncapped basis. Indeed, virtually none of the “rules“ required in a qualified plan impact a 7702 (sometimes called non-qualified) plan.
Utilizing 7702 enables a company to provide parity for highly paid employees, executives and owners. Our $400,000 owner mentioned earlier could indeed fund a tax advantaged plan to provide a $400,000 post-retirement income.
BUT WAIT – THERE’S MORE
The asset being used to accumulate and distribute these funds is a permanent form of life insurance. Repurposing cash (the premium) into “cash value“ to create this unique tax status, creates other opportunities for the business and business owner because there is an inherent death benefit provided by the life insurance contract.
Some of these opportunities are…
· Contingency capital – the cash value[2] is always accessible and is not restricted by early or late distribution rules
· The Death Benefit can be used in multiple ways without disrupting the funding or distribution process, including but not limited to…
o Estate planning – in terms of liquidity and/or equalization
o Funding “buy/sell“ agreements
o Key person coverage
o Succession planning and other forms of exit strategies
o “Perks“ such as split-dollar protection for key people
o Family income and educational funding needs
…and more.
Most of this is accomplished through drafting of agreements by counsel that would codify desired uses for the death benefit, and all of this is controlled by the owner and could be modified as circumstances change.
INTERNATIONAL ISSUES
Because life insurance contracts are the financial instrument supporting the plans discussed, and the tax ramifications of the contracts are based on IRS code, it is important that the insurance policies be U.S.-based.
In one sense this is very good, as the U.S. policies are as cost-effective as any that exist in the world. But the underwriting requirements and country-by-country treaties to make them available to non-US citizens/residents vary widely. A handful of insurance companies do have “international underwriting“ programs that will issue U.S. dollar-denominated policies on foreign nationals with a nexus to the U.S. (financial, residential, employment, etc.). Issues also apply to U.S. citizens working or residing abroad.
The many variations by country (and even city), make details on this process too complex for this article. Fortunately, one of the easiest countries to work with is Canada. Thus, issues of…
· Canadians working and/or living in the United States
· Americans working or living in Canada
· Employees and principals with “other“ citizenship
…present a lesser challenge in obtaining U.S.-based insurance contracts to support the various concepts discussed in this article.
A thorough understanding of section 7702 and other sections of the IRS code relating to U.S. life insurance contracts can provide often-missed opportunities for business owners, executives and key people, both in the U.S. and, to a large extent, Canada as well.
Mark Rooney, as an agent, offers fixed insurance products through AXA Network Insurance Agency of California, LLC and through an International Underwriting Program. As a registered representative of AXA Advisors, LLC (NY, NY 212-214-4600), member FINRA, SIPC, he is not authorized to offer securities products and services outside of the United States. AXA Advisors, its affiliates, and financial professionals do not provide tax or legal advice.
For further information or clarity on the items discussed in this article, please contact Julie Drogrez Lopez, Financial Consultant, AXA Advisors LLC at (619) 557-8427 or at Julie.DrogrezLopez@Axa-Advisors.com.
[1] All of these statistics are derived from the 2018 Life Insurance Marketing Research Association (LIMRA) Small Business Research Series Project.
[2] Loans and withdrawals reduce the policy's cash value and death benefit, and withdrawals in excess of the policy's basis are taxable. Under current rules, loans are free of income tax as long as the policy remains in effect until the insured's death, at which time the loan(s) will be satisfied from income-tax-free death benefit proceeds, and, if the policy is surrendered, any loan balance will generally be viewed as distributed and taxable.
PPG-148770 (10/19) (Exp. 10/21)