The basic pitch behind section 79 plans is the opportunity to buy cash value life insurance using pre-tax dollars. The returns on cash value life insurance tend to be low, but if you could buy them with pre-tax dollars, the after-tax returns start to look more attractive. The insurance agents sells it like this:
How would you like a retirement plan where you get?
1) An upfront tax deduction
2) Tax-protected growth,
3) Tax-free income in retirement, and
4) Don’t have to pay for an employee match into the plan?
How that Works…
Section 79 is the section of IRS Code that encourages employers to offer life insurance along with health insurance to their employees. The rules are that you can deduct the premium cost for $50,000 of group life insurance for each employee. What most companies do with that is offer $50,000 of free term insurance to their employees. It makes the employees think the employer cares about them, even though they probably need 10, 20, or perhaps 50 times as much insurance. The benefit is much cheaper than offering health insurance to the employees. In fact, premiums might only be ~$100 per person per year. So the employer gets to offer the employee a tiny amount of life insurance and write it off as a business expense. Sometimes, the employer will even let the employee buy a little bit more of the insurance, but any amount above and beyond the premiums due on the first $50K is fully taxable to the employee.
There is no rule that says the insurance offered has to be term life insurance. That’s where the insurance agents figure there’s an opportunity to sell some cash value life insurance. This is also where all the complexity comes in. A general truism in personal finance is that the more complex the product, the better it is for the guy selling it and the worse it is for the guy buying it. So when things get complicated, that’s the time to really beware. Is there a catch? Of course there is!!
The Deduction and Paying Taxes on Phantom Income
If the employer buys all the employees a $50K term policy, the entire cost of that is probably deductible. If he decides to instead offer a permanent life insurance policy, the entire cost is no longer deductible. But, if properly designed, it’s possible that 20-40% of the cost of the premium can be deductible to the employee (the entire premium is deductible to the corporation.) That’s catch # 1. Remember the insurance agent offered the opportunity to buy whole life insurance with pre-tax dollars. It’s pre-tax to the corporation, but not to you as the employee. You only get to buy 20-40% of the premium with pre-tax dollars. The rest has to be bought with post-tax dollars.
To make matters worse, you have to pay the taxes on that benefit from other income because this income to you is “phantom income”. So the employer gives you this policy (let’s say $100K premium per year), then you have to pay taxes on $60-80K of it without ever actually getting the $100K with which to pay the taxes. It’s a bit like the phantom income issue with TIPS in a taxable account that way. That’s catch # 2.
Scaring the Employees
Just like with a 401(k) or other retirement plan, you can’t discriminate against your employees. If you want to buy yourself a whole life policy, you have to offer it to your employees. That will get really expensive. The employees can choose not to participate, and you have to scare them into not taking it. You might not be a fan of whole life insurance, but if someone else is going to pay all the premiums, you’re sure as heck take the policy.
So how do employers and their insurance agents do it? They blow up the tax on phantom income issue. They say, you can either have this free $50K term insurance policy, or you can have this other policy, but then you have to pay a big tax bill on it each year. The employees will then choose the term policy despite the fact that it’s in their best interest to take the same policy as the owner, the whole life one. So if you’re going to implement this plan, either you or your agent is going to have to mislead your employees in order for you to get the intended benefit out of the plan. Having to lie to your employees is catch # 3.
You also have to use a C Corp structure to do this. An S Corp (unless you own less than 2% of it) or LLC (unless opting to file taxes as a C Corp), far more common structures for physician practices, aren’t allow to do it. That’s catch # 4.
You Have To Use a Bad Policy
Another downside of these plans is what it takes to get that full 40% deduction. It turns out the worse the whole life policy, the bigger the deduction. So what you gain on the tax side, you lose on the investment side. If held for many decades, you can get a guaranteed return of 2% and a projected return of 5% for a policy bought on a young healthy doc. Those numbers will be much lower for a policy that actually qualifies for that full 40% deduction. A better designed whole life policy might only qualify to have 5 or 10% of the cost of the premiums deducted, rather than 40%.
In fact, the polices are so bad, that most who sell them actually encourage you to get rid of them as soon as possible, which is after 5 years, by exchanging the policy into a better policy. It doesn’t hurt that the new policy also generates a new commission for the agent. However, if you actually run the numbers, you would have been better off just using your post-tax dollars (instead of 60% post-tax and 40% pre-tax dollars) to buy the good policy in the first place, not to mention investing in a better investment than cash value life insurance. Not to mention avoiding the additional costs of becoming a C Corp. Having to use a bad policy is catch # 5.
The Reportable Transactions Issue
Section 79 plans may be “reportable transactions” to the IRS. But if you don’t report it, there is a substantial penalty and fines associated with it. A plan like this also increases the likelihood of audit of the corporation. These issues with the IRS are catch # 6.