Doctors hate to pay taxes. Insurance agents love to sell insurance. Combine the two with a tax deduction the IRS offers to encourage employers to offer some life insurance to their employees and you end up with situations like Section 79 plans.
The basic pitch behind section 79 plans is the opportunity to buy cash value life insurance using pre-tax dollars. The returns on cash value life insurance tend to be low, but if you could buy them with pre-tax dollars (and of course borrow money from them tax-free but not interest free) the after-tax returns start to look a lot more attractive. The insurance agents sells it like this:
How would you like a retirement plan where you get:
1) An upfront tax deduction
2) Tax-protected growth,
3) Tax-free income in retirement, and
4) Don't have to pay for an employee match into the plan?
Sounds pretty good, right? The agents who sell this stuff describe it as “an awful lot like a combination of a traditional IRA and a Roth IRA? How about a supercharged Roth IRA? Too good to be true? It may seem so, but it is an insurance plan that has been around for years.” I wish it were that good. Unfortunately, it is too good to be true, but like usual, the devil is in the details.
How It Works
Section 79 is the section of IRS Code that encourages/allows employers to offer life insurance (along with health insurance) to their employees. The tax deduction for it is in section 162 of the code. The rules are that you can deduct the premium cost for $50,000 of group life insurance for each employee. That's cool, right? And what most companies do with that is offer $50,000 of free term insurance to their employees. It makes the employees think the employer cares about them, even though they probably need 10, 20, or perhaps 50 times as much insurance. The benefit is much, much cheaper than offering health insurance to the employees. In fact, premiums might only be ~$100 per person per year. (That's what a 30 year old healthy male can buy $50K in 5 year level term insurance for.) So the employer gets to offer the employee a tiny amount of life insurance and write it off as a business expense. Sometimes, the employer will even let the employee buy a little bit more of the insurance, but any amount above and beyond the premiums due on the first $50K is fully taxable to the employee.
However, there is no rule that says the insurance offered has to be term life insurance. That's where the insurance agents figure there's an opportunity to sell some cash value life insurance. Of course, this is also where all the complexity comes in. A general truism in personal finance is that the more complex the product, the better it is for the guy selling it and the worse it is for the guy buying it. So when things start getting complicated, that's the time to really beware. Is there a catch? Of course there is. In fact, there are six. We'll go through each of them
The Deduction and Paying Taxes on Phantom Income
So if the employer just buys all the employees a $50K term policy, the entire cost of that is probably deductible. If he decides to instead offer a permanent life insurance policy, the entire cost is no longer deductible. But, if properly designed, it's possible that 20-40% of the cost of the premium can be deductible to the employee (the entire premium is deductible to the corporation.) That's catch # 1. Remember the insurance agent offered the opportunity to buy whole life insurance with pre-tax dollars. It's pre-tax to the corporation, but not to you as the employee. You only get to buy 20-40% of the premium with pre-tax dollars. The rest has to be bought with post-tax dollars.
To make matters worse, you have to pay the taxes on that benefit from other income because this income to you is “phantom income” (you never saw it.) So the employer gives you this policy (let's say $100K premium per year), then you have to pay taxes on $60-80K of it (probably $20K or so) without ever actually getting the $100K with which to pay the taxes. It's a bit like the phantom income issue with TIPS in a taxable account that way. That's catch # 2.
Scaring the Employees
Just like with a 401(k) or other more typical employer-offered retirement plan, you can't discriminate against your employees. If you want to buy yourself a whole life policy, you have to offer it to your employees. As you can imagine, that will get really expensive. However, the employees can choose not to participate. Why would they choose not to? Well, you have to scare them into not taking it, because as much as I'm not a fan of whole life insurance, if someone else is going to pay all the premiums, I'll sure as heck take the policy.
So how do employers and their “partners in crime” insurance agents do it? They blow up the tax on phantom income issue into a huge bogey-man. They say, you can either have this free $50K term insurance policy, or you can have this other policy, but then you have to pay a big tax bill on it each year. The financially unsophisticated employees will then choose the term policy despite the fact that it's in their best interest to take the same policy as the owner, the whole life one. So if you're going to implement this plan, either you or your agent is going to have to mislead your employees in order for you to get the intended benefit out of the plan. Roccy DeFrancesco demonstrated the numbers behind this concept. He estimated that for a doctor with four employees, if he could sucker all four of them into just taking the $50K in term, his cost for that would be $475 per year. If, however, they wised up and opted for the same policy as the doctor, that same benefit would cost the doctor $27,594 per year. In short, if you actually have to buy this benefit for all of the employees, the whole thing is a non-starter. Having to lie to your employees is catch # 3.
By the way, you also have to use a C Corp structure to do this. An S Corp (unless you own less than 2% of it) or LLC (unless opting to file taxes as a C Corp), far more common structures for physician practices, aren't allow to do it. That's catch # 4.
You Have To Use a Bad Policy
Another interesting downside of these plans is what it takes to get that full 40% deduction. It turns out the worse the whole life policy, the bigger the deduction. So what you gain on the tax side, you lose on the investment side. I've run numbers before on a good whole life policy, and found that if held for many decades, you can get a guaranteed return of 2% and a projected return of 5% for a policy bought on a young healthy doc. Those numbers will be much lower for a policy that actually qualifies for that full 40% deduction. A better designed whole life policy might only qualify to have 5 or 10% of the cost of the premiums deducted, rather than 40%.
In fact, the polices are so bad, that most who sell them actually encourage you to get rid of them as soon as possible, which is after 5 years, by exchanging the policy into a better policy. It doesn't hurt that the new policy also generates a new commission for the agent. However, if you actually run the numbers, you would have been better off just using your post-tax dollars (instead of 60% post-tax and 40% pre-tax dollars) to buy the good policy in the first place, not to mention investing in a better investment than cash value life insurance. Not to mention avoiding the additional costs and hassles of becoming a C Corp. Having to use a bad policy is catch # 5.
The Reportable Transactions Issue
Section 79 plans “reportable transactions” to the IRS, or they may not, depending on who you ask. But if they are, and you don't report it, there is a substantial penalty and fines associated with it. I imagine a plan like this also increases the likelihood of audit of the corporation. As if you didn't have enough other reasons to avoid them. These issues with the IRS are catch # 6.
In conclusion, if you actually could buy permanent life insurance using pre-tax dollars for the entire premium, it would do a lot toward improving its inferior returns. However, a section 79 plan doesn't allow you to do that, and whole life insurance isn't like a Roth IRA, much less a supercharged one. Instead, a section 79 plan is another way for agents to earn huge commissions on cash value life insurance by capitalizing on your dislike of taxes while requiring you to deceive your employees. Avoid these plans and those who sell them like Ebola.
What do you think? Do you have a Section 79 plan? Have you been pitched one? Share your experience in the comments below.