The Blog

Rep. Dave Camp (R-Mich.), Chairman of the Ways and Means Committee, released a draft of the committee’s new tax reform plan last month. The plan proposes significant changes to the tax rules with major changes in how executives save for retirement.

Even though the plan is not likely to pass this year, it gives us a first glimpse into the committee’s thinking and, if we are mindful, a real opportunity to plan our wealth accumulation.

The tax reform plan seeks to reduce and compress current tax rates, increase the standard deductions, expand the child tax credit, and permanently repeal the alternative minimum tax (AMT). Yet the plan also aims to raise significant amounts of revenue to pay for these tax cuts.

The current statutory tax brackets for individuals, which currently range from 10 to 39.6 percent, would change into three brackets: 10, 25, and 35 percent. These changes would reduce individual tax rates near new lows, which could impact executive attitudes toward deferring compensation.

CHANGES IN DEFERRED COMPENSATION RULES

The reform plan would repeal sections 409A and 457A, which provide rules governing nonqualified deferred compensation plans. Proposed changes are similar to long ago changes as they relate to deferring compensation in nonprofit organizations.

The reform plan would limit the ability to defer compensation in nonqualified plans by taxing all individuals when compensation is no longer subject to a substantial risk of forfeiture; thereby eliminating the ability to defer compensation on the basis that the taxpayer does not have constructive receipt of the compensation. If a participant in such a plan vests in his own benefit, he will be taxed, which defeats the purpose of these arrangements.

NEW 401(K) RULES LAY GROUNDWORK FOR GOOD PLANNING

Under current law, employees can defer $17,500. The new reform plan proposes to cut in half this amount to $8,750, the limit that goes into a tax-deferred 401(k), and the remaining amounts required as deferred Roth contributions (after-tax). The same rules would apply to catch-up rules. The advantage with the Roth is non-taxable income in the future. With tax rules forever changing, one should plan accordingly.

THE THREE PHASES OF YOUR MONEY

To maximize your income in the face of uncertain tax rates, it’s important to think of your money across three distinct phases (see Chart I). In planning for retirement income, one should focus on the three phases of retirement income planning: the contribution phase, the accumulation phase, and the distribution phase. Understanding these phases will help you appreciate the ultimate design.

During the contribution phase, a portion of income is set aside for use in future years on a tax-deferred basis. We have always been told that “pre-tax” deferral is better than “after-tax,” but is that really true? By deferring pre-tax, we accept that all distributions at retirement will be taxed as ordinary income. The question is at what rate.

The new reform will limit the amount that can be deferred pre-tax, however, with lower tax rates today do we think they could go even lower in the future? If not, would it make sense to pay out taxes today and receive distribution non-taxable in the future?

The next phase is the “accumulation” or “investment” phase. In this phase, your money grows. We have always been told not to put all of our eggs in one basket during this phase. Truly, investment diversification is important. However, of greater importance is the non-taxable, deferred growth of the money. Roth type investment strategies are important, especially if current tax rates are low as proposed by the reform bill.

The final phase is the “distribution” phase. In this phase, the money is taxed at the time of distribution. This phase is of paramount importance. It is not what you accumulate, but what you are able to keep. This is where tax planning can pay the biggest dividends. See Chart I.

AFTER-TAX STRATEGIES WITH LIFE INSURANCE

What sets these strategies apart from traditional deferred compensation plans, as well as qualified plans, is the way participants are taxed. The participant makes contributions with after-tax dollars, but because of how insurance contracts are taxed, and accumulates all earnings on the pre-tax amount. When money is withdrawn from these arrangements, it could come out non-taxable if structured properly.

*As its funding vehicle, this insurance strategy uses as its funding vehicle an institutionally designed universal life insurance policy that has favorable tax treatment if withdrawals are made up to basis and through policy loan.

WHY THE INSURANCE STRATEGY?

The insurance strategy was designed on the premise that some percentage of your retirement savings should be in a vehicle that can generate non-taxable income during retirement, and remains safe from creditors of the sponsoring organization.

The important thing to remember and repeat is this: “It’s not how much you make, but how much you keep.” The distribution phase could be the most important phase of your retirement planning. No one knows what income tax rates will be when you retire (Chart III).

Going from a 35 percent tax bracket to a 50 percent tax bracket reduces your retirement income by approximately 25 percent. The insurance strategy distributes income at retirement without taxation, thus taking the future tax risk out of the equation. Based on the history of U.S. top income tax rates (again Chart III), how likely is it they will continue to decrease?

The insurance strategy provides the power of pre-tax savings without the contribution limits or age restrictions of qualified plans. To get the maximum value from retirement accumulation, participants should first maximize their pre-tax contributions into their 403(b), 457(b), and 401(k) plans. With the new reform bill proposing to limit those contributions and eliminate the advantages of pre-tax nonqualified plans, this maximization could be a good alternative.

HOW THE INSURANCE STRATEGY WORKS

The insurance strategy achieves its tax-advantaged status through an institutionally priced universal life insurance policy. ”Institutionally priced” means that the policy’s charges are significantly lower than comparable retail products. For example, the policy could have 100 percent cash value in year one and with no surrender charges. The cash values could be invested in a basket of mutual funds (called separate accounts) or could be used in a special fund that provides a market upside with no investment downside; that is, the S&P 500 with a cap of 12 percent and a zero return is S&P is negative. These types of funds are found only in insurance contracts.

Further, the insurance strategy is unique as a wealth accumulation plan because the policy loan feature allows a participant to take a “tax replacement” policy loan to make up for the taxes paid on the amount of any after-tax deposit. This flexibility is accomplished with key features inside the policy, along with other arrangements through third-parties.

Here is an example of the mechanics of the insurance strategy. Let’s say you were to receive a $100,000 bonus as income. You owe approximately $40,000 in taxes, which leaves about $60,000 left to invest. You could elect to invest the money in mutual funds, and assuming you were to earn 7 percent annual return, you would have to pay taxes on some portion of the gain depending on how the money was invested. Therefore, you would pay taxes each year on your gains.

With the insurance strategy, you would deposit the $60,000 in your account, and the policy loan feature would increase your balance to $100,000—the pre-tax amount of your bonus. Assuming you were to earn the same 7 percent return, your Insurance strategy cash values would accrue the gains on the entire $100,000 with no current taxation. Also, any asset reallocation between sub-accounts (investment choices in the policy) is not subject to taxation.

Later, you could make non-taxable withdrawals of both principal and interest. In addition, the insurance strategy provides the participant with a non-taxable life insurance benefit. Unlike your qualified plans, you are not forced to take the money at certain ages.

The policy loan to restore the taxes would be deducted from the policy’s death benefit, along with the capitalized interest. This deduction reduces the death benefit somewhat, but the approach still compares favorably with the mutual fund investment example, which does not provide a death benefit.

This illustration depicts the flow:

CLOSING NOTE

With the ever-changing tax rates, every executive should develop a comprehensive strategy toward wealth accumulation. One size doesn’t fit all. We should have three buckets of money to maximize the amounts we withdraw at retirement – taxed as ordinary income – taxed at capital gains – non-taxable. I encourage you to seek out a knowledgeable advisor who can help you plan your future.

See you on the upside, Bill