Income tax plans to avoid

By Roccy Defrancesco

The Wealth Preservation Institute


It's that time of year again; the time when planners gravitate to year-end "income tax reduction" strategies. Instead of spending several weeks on each individual concept you should avoid, I thought I would do a short summary of articles to put you on notice as to the concepts I think you should avoid.

419/VEBA plans. This plan just won't die. A 419 plan is an employee benefit plan that was designed to allow business owners to tax deduct the purchase of cash value life insurance where in retirement, the plan would be terminated and the policies would revert to the owners (at which time they would then borrow from the policies tax free for retirement income).

These plans were abused so much over time that the IRS has acted several times to try and kill them. Their attempts were not really successful until Notices 2007-65; 2007-83; and 2007-84 were passed. What the notices essentially said was that if an employer funded a 419/VEBA plan with life insurance, the payment is not deductible. Not only that, plans that use cash-value life (CVL) insurance were put on the listed tax transaction list. Amazingly, firms are still pitching this plan.

Today, some administrators are using these plans for a tax-favorable, post-retirement medical plan. With the advent of 401(h) plans, there is no need to use these 419 plans for post-retirement medical benefits.

The bottom line with 419/VEBA plans: Do not use them.

A/R financing plans. This is the concept that bugs me the most in our industry. When sold wrong, it is the second most dishonest sales pitch in the industry today.

How does it work? A medical practice takes a loan out against the practice's A/R and then uses that money to fund a CVL insurance policy owned by the doctor(s). Interest on the loan is paid by the practice and in retirement, the doctor can borrow money tax free from the policy.

The client is told to leverage a "dormant asset" to create retirement income. What's wrong with A/R financing plans?

1) The interest on the loan the vast majority of the time is not deductible under Title 26-Section 264(a) of the tax code. However, the main marketer of this plan that heavily recruits insurance agents, IMOs, CPAs, etc., "does not give an opinion" on whether the interest on the loan is deductible. This is absolute nonsense. What's worse is that many of the illustrations given out to clients, in fact, assume that the interest is deductible.

2) The A/R in a medical practice is not at risk to lawsuits (so the fear sale is a bogus one). Understand that I used to sue doctors for a living, ran a five-doctor orthopedic clinic for three years, and wrote what many call the "physician's financial bible." I've never heard of a medical practice losing its A/R in a lawsuit.

3) Commercial loans are problematic. While a home loan can be fixed for 30 years at a relatively low rate, commercial loans are at a higher rate and are typically fixed for less than five years. However, when an illustration is given to a client, it shows a loan interest rate at today's uncharacteristically low rates; and it is extrapolated out for 20 years (remember, in the late 1980s, interest rates were north of 15 percent).

A/R financing plans are not really year-end income tax reduction plans; but, because doctors are starting to budget for year end and the next year of their practice, many agents pitching the plan do so at this time of year. The bottom line with A/R financing plans: Do not use them.

412(e)3 plans using life insurance [formerly 412(i) plans]. Let me ask you a simple question. I want you to choose from two different investments: Investment one costs $100,000; investment two costs $150,000. If, in 10 years, both investments are worth $1,000,000, which one would you rather have? Of course, the one that costs $100,000.

Let me ask you a different question that applies to an affluent client who earns $500,000 a year and is very interested in reducing his income taxes and funding for his retirement. If you could design two tax-deductible plans where one would generate a deduction of $100,000 and the other is $150,000, which one would the business owner opt for? The $150,000 plan, so he/she can deduct and save more in current income taxes.

Would the business owner's answer change if he knew that both the $100,000 and $150,000 deductible plans would both end up with exactly the same accumulated benefit that will be used for retirement? The sad answer is "n"o, but the answer should be "yes" if the advisor helping the doctor has an IQ above 70 and gives the client proper counsel.

What am I getting at with this example? Classic 412(e)3 planning uses 49 percent life insurance when funding the plan. Because life insurance is such a crummy investment in the plan, the client is allowed to increase his/her contribution in order to reach the maximum retirement benefit.

Wouldn't the client be better off using an annuity-only 412(e)3 plan where the contribution would be less, the accumulated benefit would be the same, and where he/she would take home the difference in contributions? Absolutely. There is no question about it. Sure, the client would have to pay taxes on the difference, but any money left would put the client ahead of using a plan with a higher deduction where the retirement benefit is the same as the lower contribution plan.

This is one of my least favorite plans that is commonly pitched in the industry, and I strongly recommend you stay away from funding qualified plans with life insurance.

Putting your client's interest first at all times is imperative in today's litigious society. To act otherwise is to subject yourself to potential lawsuits from your clients should they figure out that you gave them bad advice by recommending one of the plans mentioned in this article.

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