Calculating the Real Costs will Surprise You
I’ve been on the record for nearly 15 years with my position that buying Life Insurance (hereinafter “LI”) in a Qualified Plan (hereinafter “QP”) is not only a bad idea, it’s a terrible idea. To read my newsletter titled Why Buying Life Insurance in a Qualified Plan is a Terrible Idea!, please click on the following link: Should Clients Buy Life Insurance?
My past newsletter focused on the use of cash value LI as an “investment” in a QP. This newsletter will focus on something that is almost universally ignored by those selling LI in a QP and that’s the “real” out-of-pocket costs for the death benefit coverage provided. Most advisors are under the misimpression that buying life insurance for the death benefit (vs. as an investment) inside a qualified plan with “tax-deductible dollars” is a no brainer. As you will read, it is not.
Let’s start with a little question and answer:
1) Can you buy LI in QP? Yes.
2) Is the purchase of LI in a QP tax-deductible? Partially. The premiums are 100% deductible to the business, but employees have to recapture the “costs of insurance” every year as income. Those who sell LI in QPs typically ignore this or tell the client that it’s just a miscellaneous cost (which you’ll see is not true).
3) How do you calculate the costs an employee must recapture as income? Use the Table 2001 one-year term costs and do a little calculation.
For example: For a 40 year old, the table indicates that for every $1,000 of death benefit coverage, the cost for recapture purposes is $1.10. Therefore, if an employee has a $1 million policy inside the QP, he/she would have to recapture $1,100 as income. I call the recapture of this income “phantom” income because the employee doesn’t get the money (just the tax bill for it as if he/she did get the income).
4) Does the employee receive an offset for receiving imputed income at some point in the future? Yes. The imputed income is used as a “basis;” and when the employee takes a distribution from the QP, that income can be offset by the basis.
5) The big question: Is buying something as simple as a term life policy a good idea in a QP? Answer: NO!
This is really the question I want to answer with this newsletter. With the estate tax exemption being codified at over $5 million per person (thanks to the fiscal cliff deal), I thought this would mean that millions of modestly affluent (couples with estates under $10 million) would be able to buy LI in a QP in a tax-deductible manner and have it make economic sense. I was wrong.
What factors/variables need to be used when determining if it is a good idea to buy term LI in a QP?
-Table 2001 costs employees need to recapture (which increase each year)
-Client’s current and future income tax-brackets
-Actual cost of the LI (I used 30 year level term for my example) (which becomes the employee’s basis)
-Assumed rate of return (ROR) on a side fund
A side fund is needed because the Table 2001 costs make buying LI in a QP slightly more expensive over time vs. simply taking income home, paying tax on it, and buy LI with after-tax money.
Example and outcome without that math: The math behind the following outcome is complicated. I strongly recommend you download my summary of the calculations so you can see for yourself how I arrived at the numbers. To download the summary and numbers, please click on the following link: Life Insurance facts in QP.
Example: 40-year-old male in good health. I assumed he purchased $1 million of 30-year level term LI inside the QP. The annual level premium is $1,185.
How much more did it cost the employee to buy LI inside a QP taking into account “all” the expenses vs. paying for it after tax?
After 30 years of paying premiums, it cost the employee (assumed to be the business owner) $7,221 more to buy the LI inside the QP.
If my math is correct, why would anyone buy LI inside a QP? Because it’s deductible and seems less painful? The reality is they shouldn’t. The real problem is that most advisors do not understand the math behind making this decision (which is why I wrote my book Bad Advisors).
I welcome anyone and everyone to pour over my numbers to poke holes in them. If you have any questions about them or want to debate/discuss them, feel free to give me a call.
Bottom line: We have thousands of insurance agents who recommend LI in QPs and have no idea of the variables involved or the math supporting or not supporting the recommendation. To be good at your craft, you have to know this type of information; and, hopefully, the majority of readers will find this newsletter both thought provoking and helpful.