Section 79 plans are back big time, Pt. 2
By Steve Savant
Life insurance purchased under Internal Revenue Code Section 79 provides upfront deductions in addition to the tax and economic benefits provided by permanent life insurance.
What do business owners find so appealing about Section 79 plans that causes them to buy large amounts of life insurance?
Life insurance purchased under Internal Revenue Code Section 79 provides upfront deductions in addition to the tax and economic benefits provided by permanent life insurance. They are 20 to 40 percent net tax deduction up front, with tax deferral, tax free withdrawals, tax free loans (as long as the policy remains in force), tax free death benefit and tax free living benefits.
Potential pre-tax equivalent returns usually are computed in the low double digits; 11 percent to 12 percent or more annual compounded interest rates. The plan provides large amounts of income tax-free life insurance proceeds. Tax free living benefits are available on at least one policy that qualifies for Section 79.
Picture all the benefits of an indexed universal life policy with a 30 percent to 40 percent up front tax deduction thrown into the mix.
What is IRC Section 79 and how does it work?
Surprisingly, it is the IRC section that provides companies with an income tax deduction for group life insurance up to $50,000. Most of us think it is limited to term insurance of $50,000 or less. And most of us do not realize companies get to deduct all the premiums paid to permanent group life insurance policies without limit.
The company deducts all premiums but the employee reports part of the premium, related to the permanent insurance cost, as income from the Form W-2. The cost of insurance over $50,000 is also computed and reported on the W-2. The safe harbor rules, provided by the IRS, give us tables for these two computations.
The net effect is only about 60 percent to 70 percent of the total premium is taxable to the employee. The result is an equivalent 30 percent to 40 percent income tax deduction on the overall transaction between employer and employee.
There are non-discrimination rules that have to be met. All eligible employees must be offered the same amount of insurance computed from a formula. However, all employees can opt out of the permanent insurance and only retain the $50,000 term insurance. Because the phantom income the employee has to report if they choose the permanent insurance is quite substantial, it is rare that employees accept the permanent coverage. The result is the owners and key employees end up being the people taking advantage of the permanent insurance with rare exception. Please realize this is not a program that allows the employer to exclude employees. There are non-discrimination rules, but unlike qualified plans, most employees opt out because of the tax cost.
It is critical that all employees are fully aware of the benefits available. A good plan administration company will make sure all of this is communicated properly to the employees to avoid allegations that they hid the benefits of the plan from the employees. The rules say the employee can opt out, but no doubt the IRS would frown on the provision being abused.
The fact is you do not have to hide it as the employees do not want to pay the tax cost. If the client is wary of taking a chance, one of the employees might opt to get the permanent insurance then a survey could be taken ahead of time to test that issue.
How does IRC Section 79 compare to qualified plans?
Let’s first refresh ourselves on traditional 401(k) plans and Roth type 401(k) plans and how they benefit the participants. Traditional 401(k) plans (K plans) provide a limited contribution and deduction up front, tax deferral, taxation upon distribution, a 10 percent penalty before age 59 ½ and forced distributions at age 70 ½.
Key employees and owners are more limited in their voluntary contributions to the plan, causing great frustration. The formula for key employees to participate is roughly 2 percent higher than the average non-highly compensated employee’s average contribution percentage.
Roth K plans have no deduction up front, limited contributions, tax deferral, tax free distributions after age 59 ½, a 10 percent penalty before age 59 ½ on earnings, and no forced distributions at age 70 ½. The same contribution rules apply for key employees and owners as K plans. Roth K plans allow money to build up all the way until the account holder’s death, making this more appealing to those leaving money to kids.
Section 79 plans have deductions typically of 30 percent to 40 percent up front, much higher contribution limits, tax deferral, tax free withdrawals of tax basis, tax free loans (as long as the policy remains in force), no forced distributions, no penalty before age 59 ½ and much better liquidity before age 59 ½.
Federal law protects qualified plans from creditors. State law may or may not protect cash values of life insurance from creditor claims under certain circumstances.
Which is better, a K plan, a Roth K plan or a Section 79 plan?
The K plan’s up front deduction is emotionally more attractive to most tax payers. The Roth K plan is pretty much identical to a K plan in the net after-tax income it provides at retirement, assuming income tax rates remain constant from beginning to retirement. If tax rates increase over time, then the Roth K plan comes out ahead. Most clients believe tax rates will have to increase, making the Roth concept superior over the long run. The Section 79 plan provides all the K plan benefits plus additional benefits and tax breaks. It provides higher contribution limits (no IRS limit just underwriting limits). It allows much better liquidity. It provides very significant life insurance and living benefits.
However, it has insurance costs and we are effectively limited to an indexed product. Variable life does not work for tax purposes. Clearly from a liquidity and tax standpoint, Section 79 rules the day.
However, traditional qualified plan investments may provide much higher rates of return and do not incur the costs of life insurance and living benefits. So, which concept is better depends on the client’s ability to take risk, their need for potentially higher rates of return, and if the life insurance and living benefits are worth the policy costs or not.
Who are good candidates for IRC Section 79?
Owners and key employees are frustrated with limits on funding K plans. The complexity and constant change of IRS and Department of Labor rules on traditional qualified plans are frustrating.
Other frustrations for owners are that they pay substantial plan administration fees. To benefit from the K plans themselves, they may have to match employees' voluntary contributions, incurring a large cost. They suffer through constantly changing complex IRS and Department of Labor Rules on an annual basis.
An alternative qualified retirement plan is a defined benefit plan. In most cases, defined benefit plans can provide huge deductions. However, the cost of contributions for other employees is almost always too expensive to consider this option.
New hybrid cash balance plans are a mix of defined contribution and defined benefit plans. They can maximize contributions to owners and minimize contributions to employees much more than traditional defined benefit plans. However, they suffer from high administration costs.
The rules change often on these, as well. They provide some flexibility in mandatory annual funding but the required contributions can still be oppressive.
Section 79 plans solve many of these problems and are therefore highly attractive to frustrated owners and key employees. Clients must have money to fund any type of plan, including Section 79 plans. So owners with excess cash flow who want to provide more benefits for themselves and their key employees are good prospects for Section 79.
Look for these situations for Section 79:
- Professionals making large cash flows like doctors, attorneys, CPAs and others may be good candidates.
- High-tech companies that are doing well are good candidates.
- Virtually any business wanting to escape the limits and hassles of qualified plans, with substantial extra cash flow, is a good candidate.