Aug 24, 2020

Personal Financial Planning In The Wake Of COVID-19

Time to Re-Focus on Basic Needs

Introduction

In recent years, we have all had to deal with unimagined threats to our physical and financial health. The 2008 financial crisis lead us to focus on prudent asset management; and then, after enjoying 10+ years of extraordinary equity market growth, the COVID-19 Pandemic reminded how fragile our health and the economy can be.

As a result, it may be a good time to re-think the risk management measures we have in place with respect to the financial security of our families, our investment portfolios and the threats to the value of business interests.

Specifically, to reconsider the:

  • adequacy of liquid resources,
  • investment risk tolerance,
  • security of retirement savings,
  • exposure to tax rate risk,
  • adequacy of life, disability and long-term care insurance coverages and,
  • plans in place to protect the value of business interests.

Tax Risks

Tax planning is an important component of risk management with respect to invested assets, retirement savings and any plans for transferring business interests. In a recent opinion piece in the Wall Street Journal, Philip DeMuth, the well-known investment advisor and author of several investment books, pointed out that we are currently living in a “Golden Age of Taxes – the lowest rates we may see for decades.” He goes on to summarize the potential tax increases that we could see in the not too distant future to offset the extraordinary economic stimulus spending of 2020. For example, the scheduled 2026 “sunsetting” of many of the tax benefits of the 2017 Tax Cuts and Jobs Act might be accelerated resulting in increases in individual and corporate tax rates, a reemergence of the AMT, reversal of the doubling of the federal estate tax exemption and an increase in capital gain rates and social security taxes.

He concludes the piece by suggesting,the smart move for high earners is to play defense.  Contribute to an after-tax 401(k) plan and convert your traditional IRA to a Roth. That way, you pay the taxes at today’s lower rates.”

One More Idea!

One option Mr. DeMuth failed to mention as an effective hedge against future tax increases is a life insurance-based supplemental retirement plan; a concept that has been around for many years, but which is much improved in recent years with the introduction of a wide range of competitive products.

In comparison to life insurance-based plans of years past, a contemporary program can provide competitive pricing, the flexibility to meet specific individual and/or business needs and a greater range of potential benefits. The matrix on the following page provides a comparative analysis of the key characteristics of personal after-tax savings in a mutual fund portfolio versus a contemporary life insurance-based plan.

KEY CHARACTERISTICS
Characteristic Mutual Fund Portfolio Life Insurance-Based Savings Plan
Taxation · After-tax contributions
· Partially tax-deferred accumulation
· Taxable reallocation / rebalancing
· Taxable distributions at blended ordinary / capital gain rates
“Roth-Like” tax characteristics:
– After-tax contributions
– Tax-deferred accumulation
– Tax-free reallocation / rebalancing
– Non-taxable distributions (if properly structured)
Investment Options · A wide range of individual funds
· Model portfolio options
· A wide range of individual funds
· Model portfolio options
· Equity index funds with downside protection
Contribution / Distribution Flexibility · Complete flexibility, subject to tax and liquidity considerations · Contribution flexibility, subject to possible underwriting considerations
· Non-taxable withdrawals at any time
Liquidity · Ranges from complete to limited, depending on asset class
· Possibly limited by tax considerations
· Access to policy cash value at any time through non-taxable withdrawals and loans
Security · Complete control through asset ownership (unless restricted by trust, if used)
· Fully portable
· Complete control through asset ownership
· Fully portable
Other Features / Benefits – Personal · Transfers of partial interests possible, if desired · Features designed to maximize non-taxable withdrawals while limiting tax risks.
· Optional long-term care benefits
· Significant estate planning flexibility
Other Features / Benefits – Business · Diversification of net worth: An opportunity to build assets outside business · Diversification of net worth: An opportunity to build assets outside of business
· May facilitate business succession planning, and protection of business value
Risks / Issues · Credit risk of investment / asset manager
· Market / interest rate risk
· Net Investment Income surtax (3.8%)
· Risk of adverse changes in tax law
· Insurance company credit risk
– In some, but not all, cases
· Market / interest rate risk
– Offset by downside protection in equity index products
· Potential impact of underwriting
· Risk of adverse changes in tax law

Comparative IRR:  Life Insurance vs. Mutual Fund Portfolio

The following is a hypothetical analysis of the internal rates of return from an investment in a contemporary variable universal life insurance (VUL) contract versus a portfolio of mutual funds.  The assumptions on which the analysis is based are included below.

Observations:

  • The projected after-tax IRR in the short-term is better with a mutual fund portfolio because of the up-front loads and expenses associated with the VUL contract (see the following page for a comparative analysis of expenses)
  • However, over the long term, the projected after-tax IRR of the VUL contact (with or without consideration of the death benefit) is superior to that for the mutual fund portfolio.
  • A contemporary life insurance-based supplemental retirement plan providing a combination of tax-advantaged savings, protection against future tax increases and cost-effective insurance coverages could be a valuable component to your personal financial plan.

Expense Comparison

The following is an analysis of the projected loads and expenses of the hypothetical VUL contract in comparison to the projected tax cost of the hypothetical mutual fund investment. The comparative advantage is highlighted in green.

Observations:

  • The projected tax costs of the mutual fund portfolio are less than the projected loads and expenses of the VUL contract in the early years; but,
  • When viewed from a long-term perspective, the VUL contract may represent a more cost-efficient savings vehicle, and it provides a number of additional financial planning / risk management benefits.

In Summary

If it is time to re-think your personal financial plans and risk management measures, consider including a contemporary life insurance-based supplemental retirement plan in the mix.  A well designed and properly administered program may represent a valuable addition to your long-term financial plans, providing:

  • Tax-advantaged liquid savings
  • A hedge against future tax increases,
  • A significant death benefit (and optional chronic illness benefits),
  • Protection of the value of business interests and,
  • Professional management, essential to maximizing benefits and minimizing tax risks.

For more information about how EBS could help in this regard, please visit our website at: www.executivebenefitsolutions.com.

May 29, 2020

NQDC PLANS: LESSONS LEARNED IN THE COVID-19 ERA

Can I Withdraw Funds From my Account, or Freeze Deferrals?

We have all learned a few lessons in recent months as we struggle to cope with the sudden and dramatic changes to our personal lifestyles, and to the pursuit of our business interests.  Among the most important is the need for liquidity.

While we have always known that maintaining a liquid asset reserve is a fundamental principle of prudent financial management, we have just received a very clear reminder.

COVID-19 Triggers a Search for Cash

Over the last few months, our firm has received a number of calls from participants in NQDC plans asking if it is possible to either cancel deferral elections for the current year, and/or withdraw cash from their account. They may have read that the CARES Act included certain relief provisions for participants in a Section 401(k) plan that permit loans and withdrawals on a favorable basis. Unfortunately, there are no such relief provisions in the Act for NQDC plans.

Liquidity Options with NQDC Plans

Non-qualified deferred compensation plans have long been, and continue to be, a fundamental component of the total rewards package for executives and other key employees.  They provide an opportunity for supplemental tax-advantaged savings for participants and an effective incentive and retention tool for the employer/plan sponsor.

While non-qualified plans offer significant flexibility of plan design, the liquidity of a participant’s account is limited. In response to a few high-profile corporate scandals, Congress substantially re-wrote the tax law covering non-qualified deferred compensation programs in 2005. Under new Section 409A, withdrawals and distributions from a participant’s deferred compensation account are restricted to specific events, the timing of distributions and withdrawals must be elected up-front at the time of deferral, and the acceleration of benefits is generally prohibited.

However, there are some options available to a participant in a NQDC plan in search of cash.

  • “Hardship” Withdrawal and Suspension of Deferrals: May be permitted under Section 409A, but it is subject to significant restrictions as discussed below.
  • Distribution of Pre-Section 409A portion of account balance:  If the plan includes pre-Section 409A grandfathered accounts from years prior to 2005, there may be more flexibility to access that portion of a participant’s account under the old tax rules.
  • Plan Termination:  It is possible for an employer/plan sponsor to terminate a NQDC plan on a discretionary basis and liquidate all participants’ accounts.  However, it may not be effective in meeting an immediate need for liquidity.
  • Cash-out of a Small Account Balance: Finally, many NQDC plans have a provision that permits the employer/plan sponsor to cash-out a small balance in a participant’s account. However, once again, this provision is of relatively little value to satisfy a significant cash need.

Hardship Withdrawal for an Unforeseeable Emergency

A NQDC plan may allow distributions, based on a “severe financial hardship” resulting from:

  • Illness or accident to the participant or his or her spouse or dependent,
  • Property loss caused by casualty not covered by insurance,
  • Funeral expenses and,
  • Other extraordinary and unforeseeable circumstances resulting from events beyond the control of the participant.

While it may seem counterintuitive, suffering a reduction in pay or being furloughed from your job as a result of COVID-19 may not qualify as an “unforeseeable emergency” under the strict rules of Section 409A.  Note that these rules are different from, and more restrictive than, the requirements for a hardship withdrawal from a Section 401(k) plan.

Furthermore, to obtain a hardship distribution from your account, you must show that the need for cash could not otherwise be met by insurance, or the liquidation of other assets; and, the amount of the hardship distribution is limited to the amount needed to satisfy the emergency, plus applicable taxes.

Cancellation of Current Year Deferrals

Deferral elections under a NQDC plan made for the current year are generally irrevocable. A different election could be made for the following year; but the election for the current year cannot be changed. However, if you can establish that an “unforeseeable emergency” has occurred, and your employer approves the request, then the plan may permit the suspension of deferrals under an exception to the general anti-acceleration rule.

In one recent case among the companies with which we work, the employer approved requests by participants for a hardship distribution and/or the suspension of deferrals based on their representations and warranties that the COVID-19 crisis has caused them to suffer a severe financial hardship due to an unforeseeable emergency (as defined under the plan and applicable tax law), and that the amount of the requested distribution did not exceed the amount necessary to satisfy the financial emergency (plus taxes) after taking into account insurance and/or the liquidation of other assets.

A second narrow exception to the general rule prohibiting the cancellation of a deferral election is the disability of the participant. Note, once again, that the definition of “disability” for this purpose is different from other definitions.

Access to Pre-409A, “Grandfathered” Accounts

Some NQDC plans that were implemented prior to the January 1, 2005 effective date of Section 409A have a segregated component of participants’ accounts related to compensation deferred and vested before December 31, 2004 (“grandfathered accounts”).  In that case, distributions and withdrawals may be subject to the generally more favorable tax law in effect prior to Section 409A. For example, the pre-409A plan might provide for a discretionary 10% “haircut” withdrawal.

Small Balance Cash Out

Many NQDC plans have a provision that permits a lump sum distribution of a participant’s account if the balance is below the Section 402(g)(1)(B) limit (the maximum amount of elective deferrals for a Section 401(k) plan).

This liquidity option is of limited or no value to most participants; but is an alternative the employer/plan sponsor should be aware of.

Termination and Liquidation of a NQDC Plan

As noted above, several of the key provisions of Section 409A were written from an anti-abuse perspective; that is, to prevent some of the perceived abuses of NQDC plans that may have occurred in the past. One of those provisions prohibits the acceleration of benefits under the plan.  However, there are certain exceptions, for example, in the case of a change-in-control.  Another exception to the anti-acceleration rule is for the discretionary termination and liquidation of the plan, subject to strict guidelines:

  • The termination must not be related to a downturn in the financial health of the company,
  • All NQDC plans of similar design sponsored by the employer must also be terminated,
  • No new non-qualified replacement plan may be implemented for 3 years and,
  • The payments to participants in liquidation of their accounts must not begin until 12 months after the date of the termination and must be completed within 24 months.

As a result, a discretionary termination of a NQDC plan is not a simple solution to an immediate need for liquidity among the participants and has a number of other implications.

Financial Planning Lessons Learned from COVID 19

  1. It’s time to re-think your strategy: To re-consider the allocation of savings and retirement assets to maximize growth potential while minimizing risk by taking into consideration the timing of cash needs, appropriate asset class diversification and the creation of a non-taxable “bucket” of retirement savings.
  2. A NQDC plan is a long-term savings vehicle. While a NQDC plan is a powerful, tax-advantaged savings vehicle, it is long-term in nature that provides limited options for short-term liquidity. And unfortunately, unlike 401(k) plans, there are no relief provisions in the CARES Act for NQDC plans.
  3. Actively manage NQDC plan distributions. To provide a degree of liquidity and maximum flexibility, take advantage of the short term “in-service” distributions and re-deferral provisions under the plan:
    • For example, you could defer compensation earned in 2020 for the minimum deferral period under the plan (say to 2022), and then in 2021, 12 months prior to specified 2022 distribution date, re-defer the distribution until 2027 (five years out or later). You could cascade these short-term deferrals year after year.
    • In 2021, if you expect a need for cash in 2022, you could stick with the original 2022 in-service distribution election.
  4. Consider tax-qualified plans. While the savings benefits of a 401(k) or other tax-qualified plan are limited for highly compensated employees and professionals, they may have greater flexibility to meet an immediate need for liquidity. You should always consider maximizing qualified plan savings first before electing to participate in a NQDC plan.
  5. Contribute to a Roth IRA, too. After you fill your 401(k) bucket, consider using a Roth IRA to diversify the tax treatment of retirement income. You can contribute up to $6,000 to a Roth IRA in 2020 in addition to your 401(k).
  6. Consider a life insurance-based supplemental savings plan.  Contemporary programs, using significantly improved products in recent years, offer “Roth-like” tax characteristics, competitive investment options (including some with downside protection), liquidity, freedom from contribution and distribution restrictions, portability and cost-effective life insurance coverage.

Work with Unbiased Financial Advisors

In light of the lessons learned from the 2008 financial crisis and from COVID-19, we recommend that you consider working with a financial and tax advisor to obtain a clear picture of the role that non-qualified deferred compensation all other savings and retirement options should play in achieving your financial goals.

  • Executive Benefit Solutions, LLC is an independent consulting firm that specializes in the design and management of supplemental compensation and benefit plans structured to meet the specific needs of highly compensated executives and professionals. More information about the firm can be found at: www.executivebenefitsolutions.com.
  • My Financial Coach, LLC offers a precision financial planning platform to model investment and savings and retirement options on a coordinated basis with your personal assets and corporate benefits. My Financial Coach will match you with a Certified Financial Planner® (CFP) with the knowledge and tools to help you in the planning process. More information about My Financial Coach can be found at: www.myfinancialcoach.com.