Planning Realities for High Net Worth

 Helping high-paids in a high-tax environment

by Brian Ashe, CLU

Sometimes we consider high income earners and high net worth individuals to be “insulated” from economic downturns. Yet, after the last big market downturn, about one third of the top one percent of earners were gone from that list, one that they were on only two years earlier.

Adding to that decline, the Taxpayer Relief Act of 2012 didn’t offer much “relief” to highly compensated executives. Income tax brackets were raised to 39.6 percent for those filing a joint return with a household income over$450,000. Additionally, capital gains taxes increased to 20 percent, along with a new Medicare Surtax of 3.8 percent. This surtax applied to the lesser of investment income or the Modified Adjusted Gross Income over$250,000 for joint filings, and over $200,000 for single filings.

Put those together with state income taxes and, in some cases municipal income taxes, now there are some real challenges for top earners to “keep what they earn.” When highly compensated executives try to keep more of what they earn through participation in the same qualified plans available to less highly paid employees, they run into caps that limit the amount of income they can save.

The lower paid employees can put away a larger percentage of their incomes than the highly paid. In fact, some say the qualified plan limits on contributions actually “discriminate” in favor of the lower paid employees. Is there anything else these highly paid employees can do? Is there anything else their employers can do to recruit, retain and reward high performers? Certainly one answer has to be the increased attractiveness of “non-qualified” plans such as Non-Qualified Deferred Compensation and Supplemental Employee Retirement Plans (SERP’s).

How do these types of plans work?

Well, nothing is without complication but here are some general principles:

• An employee agrees to defer some of their compensation or, in the case of a SERP, the employer supplements compensation but defers the actual payment of that supplemental income to the employee.
• The deferred income is not taxed to the employee until it is actually paid to the employee
• The deferred income can grow tax deferred.
• FICA taxes may be due during the deferral period or during the distribution period, depending on what type of plan is in place.
• The plan does not have to be offered to all employees or even to all highly paid employees.
• Any assets of the plan belong to the employer during the deferral period and are subject to the claims of the employer’s creditors.
• Most importantly, there is no limit to the amount that can be deferred, subject to IRS rules on “reasonableness” of total compensation

Most often, these plans are funded with an institutional type life insurance policy that generates significant early cash values both to fund living benefits to the participants and death benefits to the sponsoring employer. Those death benefits help to recover plan costs for the employer and can even be used to pay an additional death benefit to the employee’s survivors.

Of course, under current law, both employer and employee need to sign special notices acknowledging the life insurance is being applied for and owned by the employer. Why use a life insurance policy to “informally” fund this type of arrangement? Simply because it’s generally the best financial tool for the task. Employers can pay their financial obligations for these plans out of current corporate cash flow or from some sinking fund arrangement. Either way, each year that goes by, the liability for the future payments to employees grows.

For those employers who try to amortize that liability each year, their challenge is to match assets and earnings each year to the liability that’s accrued each year. This means they also have to pay close attention to income taxes on the income earned on those assets.

Since the employees’ deferred compensation is growing tax deferred and the company’s assets to match that liability are growing in taxable accounts, the income taxes to the employer can cause a mismatch in values—the taxable accounts can’t keep up with the tax deferred liability. That mismatch grows every year. Compounding the problem, gains from corporate owned mutual funds are not taxed at lower capital gains rates, they are taxed at higher ordinary income rates.

Enter the life insurance solution

Life insurance offers tax deferred cash value increases, tax free withdrawals equal to the premiums paid, access to tax free loans and, ultimately, income tax free death benefits. It is the perfect tool to better match assets and liabilities for deferred compensation plans. What about the cost of insurance, is this a factor? Mutual funds don’t have this cost, but the cost of the death benefit on life insurance is still significantly less than the cost of the taxes on the other investment options—like mutual funds! Combine the cost recovery benefits at death with the tax favored benefits during life and that’s why the largest preponderance of big and small companies with deferred compensation plans rely on the financial superiority of life insurance as their funding vehicle.

Both variable life insurance and fixed value contracts can be used. Because of the high early cash values needed on these contracts to mitigate negative early results on a company’s balance sheets, compensation to the advisor is most often leveled.

Potential employee participants should be aware that the continuity of their employer’s business and the company’s credit worthiness are important factors in reasonable assurance that the employees deferred compensation will be there when it’s time for a payout. Employers, per government regulations, must have significant advance notice from an employee of a request to change the time of a previously agreed to payout. Lastly, for us as advisors, the “sale” of deferred compensation is just the beginning.

These cases are service intensive and most employees today want the same facility of informational access to the values of their accounts as do participants in 401(k) plans. Because of this, advisors have to be sure that they ally themselves with an experienced deferred comp service provider. The provider has to be able to provide access to daily values to participants and comprehensive reports to the employers.

These servicing organizations will charge a fee to the employer and many work on a split commission basis with the advisor. The good ones are worth their weight in gold and will free you up to do what you do best—help people create and distribute wealth more efficiently. With today’s population benefitting from increased longevity and challenged by increased taxation, modern life insurance contracts offer unique tools to make financial life better for employers and employees.

For top income earners, these contracts should be the tool of choice for accumulation, distribution and legacy. All we have to do is start the conversation.