Section 79 plans, Pt. 2: Lying to employees to implement plansArticle added by Roccy DeFrancesco on April 16, 2010
Ranked: #5 (10,567 pts)
Before beginning this article, I wanted to reiterate my comments on implementing plans with fewer than 10 employees
Group underwriting for businesses of 10 employees or less
For businesses with 10 or fewer employees, the law prohibits full medical underwriting of the policies that are issued ("group" underwriting is required, which is much more risky for an insurance company). Amazingly, one of the insurance companies offering this plan seemly doesn't have the ability to issue non-medical underwriting policies. This is laughable and pathetic all at the same time, and a plan you'll want to stay far away from.
As I briefly alluded to in my previous article, one of the reasons I really do not like Section 79 plans is that they basically force employers and those helping them set up Section 79 plans to lie to the employees when implementing the plan.
Section 79 plans are employee benefits plans. As such, employers are not supposed to discriminate in favor of key employees or business owners.
As you know, Section 79 plans are implemented so business owners can take a business deduction for the purchase of an individually owned life insurance policy that the owner can borrow from tax free in retirement.
It sounds great until you break down the math and understand that a client would be better off paying taxes on his/her money, taking it home, and funding a good cash value life policy rather than the low cash accumulation Section 79 Plan policy.
Notwithstanding the math behind Section 79 plans, let's talk about the benefits for employees. The employee owner is going to buy a "permanent" policy that will carry cash and can be borrowed from tax free in retirement.
That same policy must be offered to all employees. If that actually happened in a full-disclosure manner, virtually all the employees would opt for the same permanent policy; and if that happened, the finances of the plan would really go out the window because of the tremendous costs for the employees.
How do you "work around" this issue?
The work around of this issue is a bit clever and deceptive. The employees will be scared into voluntarily opting for $50,000 of term insurance instead of the full-benefit policy (term or permanent).
Why would an employee opt for $50,000 in term instead of a policy with several hundred thousands of dollars or even millions of dollars in death benefits? Because employees who are provided death benefits by an employer in excess of $50,000 are taxed on the additional benefit on an annual basis (and it increases every year).
The scare pitch
You sit the employees down in a room and tell them that the business is going to be implementing a Section 79 Plan as a new employee benefit plan. Initially, all the employees are shocked and pleased.
Then the person doing the enrollment meeting tells the employees that for free, they can receive $50,000 of term insurance or more death benefit coverage. However, the employees are told they will get an income tax bill for the additional coverage. The employee is typically led to believe that the tax bill will be quite high and that this will be money out of their pocket when they pay the tax on income they did not receive.
Then, they are all given the opt-out form for the higher amount at which point they all opt for $50,000 of term life insurance.
When you see the numbers, you'll know why an employee would have to be truly stupid not to opt for the full benefit and why it is so important to scare employees to opt out.
What you'll notice is that the cost of having the employees opt for permanent policies totals $27,594 a year, and that the cost for the employees' opting for $50,000 in term totals $475 a year.
What you'll notice is that the taxable income for the employee with the highest amount of recapturable income is $6,112 a year for a $9,404 corporate premium. This amount is not the tax; it's the additional income. If the employee is in the 20 percent tax bracket, that's an additional income tax bill of only $1,222 a year. Would Employee No. 1 below pay $1,222 a year to have the employer fund $9,404 as a premium into a permanent cash value life insurance policy that can be borrowed from tax free in retirement? This, of course, is a question that only has one answer. Employee No. 1 would also have to recapture $264 of additional income for insurance provided above $50,000 of term coverage.
Should you be selling Section 79 Plans?
Sure, if you like the idea of lying or withholding information from clients to make the sale.
Sure, if you like the idea of doing enrollment meetings for employees where you have to lie to them so the plan can be implemented in a financially economical manner.
I think that the Section 79 plan is one of the most abused concepts in our industry today, and I hope my full disclosure information on these plans has been helpful to you as you can make the decision about using these plans for your clients.
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