Clients cannot control market behavior, but they do hold sway over how they manage taxes. Determining the optimal tax deferral strategies depends on a client’s income, net worth and estate planning objectives. Educating clients about the benefits of tax-deferred compounding in retirement plans and insurance strategies is a valuable service that we as planners can deliver.
We examine the hierarchy of options, from well-known retirement plans to more complex insurance-based strategies. For example, one should max out retirement plan contributions and take advantage of the ‘low hanging’ fruit before considering more complex options. Below is a summary of the major tax deferral strategies that we as planners consider for our clients.
Basic Retirement and Benefit Plans
Traditional and Roth 401(k) plans are among the more common retirement plans. Clients should be encouraged to contribute the maximum amount to these plans and take advantage of their company’s matching component. The contribution limit in 2022 is $20,500, enhanced by an additional $6,500 for clients who are 50 years of age or older. Profit sharing plans — which may include a 401(k) component — may have an even higher contribution limit of $61,000 in 2022 and the same $6,500 catch-up provision for clients over 50. Business owners who can muster the discipline to save excess profits can benefit immensely from these plans, especially if the business employs the owner’s spouse as well.
IRAs, including traditional, Roth, SEP, and SIMPLE, typically have lower contribution limits — although SEP IRAs allow for a maximum contribution of $61,000 in 2022.
A health savings account (HSA) is another option available to employees whose companies offer these vehicles as part of their health benefits package. Enrollment in a high deductible health plan is a requirement. HSAs are triple tax advantaged: 1) The salary to fund them is deferred on a tax-free basis, 2) earnings and growth are not taxed, and 3) funds can be withdrawn tax-free so long as they are used to fund qualified medical expenses. Individuals may contribute up to $3,650 in 2022, with a family limit of $7,300. Those 55 and older may contribute an additional $1,000 (but not if enrolled in Medicare). Note that not all states, such as California and New Jersey, allow a state income tax deduction for these contributions.
Small Business Owners and Pension Plans
Small business owners who have high income and a small number of employees can reap major advantages from defined benefit plans. Defined benefit plans may allow for tax-deductible contributions as high as 50% to 80% of compensation, depending on age, years of service, and the type of business. An actuary calculates the company’s annual contribution limits, and IRS rules cap the annual benefit, which in 2022 is $245,000. The business owner/employer bears the responsibility for making investments to fund the retirement benefits.
Cash balance plans are a variation of a defined benefit plan. Rather than guaranteeing a set monthly benefit, these plans give the employee a finite balance upon retirement, with the employer assuming responsibility for investment decisions. Think of them as a hybrid plan, combining the higher contributions of a defined benefit plan with the flexibility of a defined contribution plan. Cash balance plans may be less expensive for employers to administer than traditional defined benefit plans.
Long touted as the premier tax-deferred investment product, qualified and non-qualified annuities offer an income stream that is expected to help fund the owners’ expenses throughout retirement. However, there are potential drawbacks that may include loss of control or limited investment options, low interest rates, high fees, lack of liquidity, and reduced purchasing power overtime. Variable annuities and guaranteed benefit riders are a couple of ways to address these drawbacks.
We suggest analyzing the costs and benefits of an annuity product versus investing in a well-diversified portfolio within the client’s risk tolerance. The analysis should include Monte Carlo simulations modeling the financial events that may occur during a client’s life. Sometimes the choice to purchase an annuity is psychological: Clients like the idea of guaranteed income and are willing to pay a cost for it.
Permanent Life Insurance for Tax-Deferred Growth
Once retirement savings plans are maxed out, permanent life insurance is another vehicle clients can use to accumulate tax-advantaged assets. These policies come in the form of whole life and universal life, both of which last for a lifetime. In contrast, term life has a finite timeline.
Whole life policies have fixed premiums, dividends and death benefits. Universal life policies may have flexible premiums, dividends and death benefits. Premiums on whole life policies are usually higher than universal life premiums and offer a guaranteed growth rate on the cash value, though it is likely less than on other investment options. Universal life policies offer more optionality in selecting investments for the cash value component, providing greater opportunity for upside.
Whole life and universal life policies give the policyholder the option to take loans or withdraw funds from the cash value, which can be a tax-free funding source. When the policy pays out the death benefit, the loan is paid off and the remaining amount is distributed to beneficiaries.
These benefits may help rationalize the higher expense of permanent life insurance over lower-cost term policies. For example, a healthy 45-year-old person with a $5 million policy can expect to pay around $8,500 in monthly premiums. The cash value accumulates tax-free over time.
The costs and benefits must be evaluated against buying a cheaper term policy and investing the balance in a well-diversified portfolio. Advisors can make informed recommendations only if their analysis incorporates the client’s entire wealth plan and Monte Carlo simulations.
Permanent Life Insurance for Children
Some clients may opt to purchase permanent life insurance policies for children. Premiums are lower than premiums for adult policies, the child is likely more insurable than an adult, cash value accumulates, and the same loan and withdrawal features are available throughout the child’s lifetime. The ability to purchase additional coverage, known as guaranteed insurability (with fewer restrictions on health or occupation), is another feature of some of these policies. The drawback is that death benefits are likely much lower.
Private Placement Life Insurance
Ultra-high-net-worth clients have an additional avenue available to them in the form of private placement insurance. In addition to the typical death benefit, wealth-building and tax-deferral attributes, private placement life insurance (PPLI) offers an array of investment choices. This includes hedge funds, private equity partnerships and other alternative investments.
PPLIs offer an extra benefit — the ability to defer estate taxes — making them ideal for clients who have a long-time horizon and who wish to make large wealth transfers. The administrative costs are around .60%; other fees such as state tax on premiums can increase total fees to 1.00%.
Private placement policies are administered by an insurance company and the client generally selects their own wealth manager to manage the investments. Large insurers, such as Prudential Pacific Life, and Zurich, as well as smaller providers, including Lombard, Crown, Investors Preferred, and Advantage, all offer private placement life insurance.
The policy may be taken out on anyone in whom the policyholder has an insurable interest. The insurance company is the beneficial owner, upon whom the policyholder has a claim up to the value of the policy. Note that the client must give the advisor full discretion to oversee the underlying managers and make rebalancing decisions. These polices are often held by dynasty trusts and irrevocable life insurance trusts.
Private placement life insurance policies demand significant upfront premium funding: A minimum of $1.25 million each year for the first four years is usually recommended. Clients considering these structures should have a minimum net worth of $20 million, of which $10 million should be liquid and they work with a broker who specializes in PPLI. And they must have reasonable certainty that the tax-adjusted return will outweigh the premium cost. It can be a heavy lift and a high barrier to entry.
In turbulent markets, it is important for clients to focus on what they can control. A host of tax-deferral strategies is available to help clients achieve tax alpha. Guidance from a wealth planner is important to help determine the options that will likely result in the best outcomes. Weighing costs against the tax-adjusted return will be a major consideration in the process.
Mallon FitzPatrick, CFP®, is a principal, managing director, and head of Wealth Planning at Robertson Stephens, a wealth management firm providing innovative and comprehensive wealth planning and investment solutions through an intelligent digital platform.