June 30, 2022 – You cannot control market behavior, but you do hold sway over how you manage taxes, which reduce investment returns on portfolios and are often compounded by state taxes. Determining the optimal tax deferral strategies depends on your income, net-worth and estate planning objectives. Reviewing the benefits of tax-deferred compounding via retirement plans and insurance strategies is an important part of our planning relationship. Let’s examine the hierarchy of options, from well-known retirement plans to more complex insurance-based strategies. For example, one should max out retirement plan contributions and take advantage of the ‘low hanging’ fruit before considering more complex options. Below is a summary of the major tax deferral strategies.
Basic Retirement and Benefit plans
Traditional and Roth 401(k) plans are among the more common retirement plans. We encourage clients to contribute the maximum amount to these plans and take advantage of your company’s matching component. The contribution limit in 2022 is $20,500, enhanced by an additional $6,500 for those who are 50 years of age or older. Profit sharing plans – which may include a 401(k) component – have an even higher contribution limit of $61,000 in 2022 and the same $6,500 catch-up provision for those over 50. Business owners who can muster the discipline to save excess profits can benefit immensely from these plans, especially if the business also employs the owner’s spouse.
IRAs, including traditional, Roth, SEP, and SIMPLE, typically have lower contribution limits—though SEP IRAs allow for a maximum contribution of $61,000 in 2022.
A Health Savings Account (HSA) is another option available to employees whose companies offer these vehicles as part of their health benefits package. Enrollment in a high deductible health plan is a requirement. HSAs are triple tax advantaged: (i) The salary to fund them is deferred on a tax-free basis, (ii) earnings and growth are not taxed, and (iii) funds can be withdrawn tax-free so long as they are used to fund qualified medical expenses. Individuals may contribute up to $3,650 in 2022, with a family limit of $7,300. Those 55 and older may contribute an additional $1,000 (but not if enrolled in Medicare). Note that not all states, such as California and New Jersey, allow a state income tax deduction for these contributions.
Small Business Owners and Pension Plans
Small business owners who have high income and a small number of employees can reap major advantages from defined benefit plans. Defined benefit plans may allow for tax-deductible contributions as high as 50% – 80% of compensation, depending on age, years of service, and the type of business. An actuary calculates the company’s annual contribution limits, and IRS rules cap the annual benefit, which in 2022 is $245,000. The business owner/employer bears the responsibility for making investments to fund the retirement benefits.
Cash Balance Plans are a variation of a defined benefit plan. Rather than guaranteeing a set monthly benefit, these plans give the employee a finite balance upon retirement, with the employer assuming responsibility for investment decisions. Think of them as a hybrid plan, combining the higher contributions of a defined benefit plan with the flexibility of a defined contribution plan. Cash balance plans may be less expensive for employers to administer than traditional defined benefit plans.
Annuities
Long touted as the premier tax-deferred investment product, qualified and non-qualified annuities offer an income stream that is expected to help fund the owners’ expenses throughout retirement. However, there are potential drawbacks that may include loss of control or limited investment options, low interest rates, high fees, lack of liquidity, and reduced purchasing power overtime. Some annuities and riders address these drawbacks such as variable annuities and guaranteed benefit riders to name a few. We analyze the costs and benefits of an annuity product versus investing in a well-diversified portfolio within your risk tolerance. The analysis includes Monte Carlo simulations modeling the financial events that may occur during your life. Sometimes the choice to purchase an annuity is psychological: those who like the idea of guaranteed income are willing to pay a price for it.
Permanent Life Insurance for Tax-Deferred Growth
Once retirement savings plans are maxed out, permanent life insurance is another vehicle you can use to accumulate tax advantaged assets. These policies come in the form of whole life and universal life, both of which last for a lifetime versus term life which has a finite timeline.
Whole life policies have fixed premiums, dividends, and death benefits. Universal life policies may have flexible premiums, dividends, and death benefits. Premiums on whole life policies are usually higher than universal life premiums and offer a guaranteed growth rate on the cash value though it is likely less than on other investment options. Universal life policies offer more optionality in selecting investments for the cash value component, providing greater opportunity for upside. Both types of policies give the policyholder the option to take loans or withdraw funds from the cash value, which can be a tax-free funding source. When the policy pays out the death benefit, the loan is paid off and the remaining amount is distributed to beneficiaries.
These benefits may help rationalize the higher expense of permanent life insurance over lower-cost term policies. For example, a healthy 45-year-old person with a $5 million policy can expect to pay around $8,500 in monthly premiums. The cash value accumulates tax-free over time and the owner can take loans against the policy to fund expenses, ideally after the insurance benefit is needed for income replacement in the event of premature death.
The costs and benefits must be evaluated against investing an equivalent amount, plus term insurance to replace income, in a well-diversified portfolio. To make informed recommendations the analysis must incorporate your entire wealth plan and Monte Carlo simulations.
Permanent Life Insurance for Children
It’s possible to purchase permanent life insurance policies for children. Premiums are lower than premiums for adult policies, cash value accumulates, and the same loan and withdrawal features are available throughout the child’s lifetime. The ability to purchase additional coverage, known as guaranteed insurability (with fewer restrictions on health or occupation), is another feature of some of these policies. The drawback is that death benefits are likely much lower.
Private Placement Life Insurance
Ultra-high-net-worth investors have an additional avenue available to them in the form of private placement insurance (PPLI). In addition to the typical death benefit, wealth-building, and tax-deferral attributes, PPLI offers an array of investment choices, including hedge funds, private equity partnerships, and other alternative investments. They offer an extra benefit—the ability to defer estate taxes—making them ideal for those who have a long-time horizon and who wish to make large wealth transfers. The administrative costs are around 0.60%, other fees such as state tax on premiums can increase total fees to 1.00%.
The investments are administered by an insurance company, and you may select an asset manager, usually it’s your wealth manager. Large insurers, such as Prudential Pacific Life, and Zurich, as well as smaller providers, including Lombard, Crown, Investors Preferred, and Advantage, all offer private placement life insurance.
The policy may be taken out on anyone in whom the policyholder has an insurable interest. The insurance company is the beneficial owner, upon whom the policyholder has a claim up to the value of the policy. Note that you must give your advisor full discretion to oversee the underlying managers and make rebalancing decisions. These polices are often held by Dynasty and Irrevocable Life Insurance Trusts.
Private placement life insurance policies demand significant upfront premium funding: a minimum of $1.25mm each year for the first 4 years is typically recommended. Investors considering these structures should have a minimum net worth of $20 million, of which $10 million should be liquid and work with a broker who specializes in PPLI. And you must have reasonable certainty that the tax-adjusted return will outweigh the premium cost. It can be a heavy lift and a high barrier to entry.
Summary
In turbulent markets, it is important for you to focus on what you can control. A host of tax-deferral strategies are available to help you achieve tax alpha. Guidance from a wealth planner is important to help determine the options that will likely result in the best outcomes. Weighing costs against the tax-adjusted return will be a major consideration in the process.
Disclosure
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