Section 79 plans may not be the wisest decision even though many small business owners would like to benefit from the 20-40% tax deduction salesmen are touting. We look at why the Section 79 gives lesser returns than other retirement plans and thus even with the tax deduction, they don’t make good financial sense. The following article discusses the disadvantages to using a Section 79 Plan.

Section 79 and Life Insurance Planning

Less than 10 Employees? Use Group Underwriting

If a business owner has 10 employees or less, laws restrict eligibility for any policy that has full medical underwriting. Instead, group underwriting will be required. Many insurance companies do not like group underwriting because these policies are more of a risk. When the math is revealed you will understand the reason these plans should be avoided for asset protection and tax minimization.

Section 79 Plans Disadvantages

The reason the Section 79 plans are so marginal is because the insurance policy that is being purchased, by nature and inheritance, is set up poorly to get the full deduction. In other words, the types of cash value life insurance policies resulting from the Section 79 do not return a lot of money in retirement. It would be more beneficial for the business owner to take a smaller deduction and have a better cash value life insurance policy. With a quality CVL (i.e. Cash Value Life), the business owner would receive a deduction of only between 5 and 8% which hardly makes economic sense. So how does a quality Cash Value Life policy compare with the Section 79 returns in retirement? Please read on.

Section 79 Results: After Five Years Convert to a EUIL or Variable Life Policy

After five years, clients will have the option to convert the Section 79 Plan into a better policy, such as an EIUL (Equity Indexed Universal Life) or variable life policy. These life policies can earn around 9% each year. However, even with the presumption that the rate of return will be 9%, the retirement returns are comparatively less than the policies we use.

Life Insurance Agents Who Sell Section 79 plans

Why do life insurance agents push Section 79 Plans without full disclosure? Agents have two reasons for pushing these plans. Firstly, business owners hate paying taxes and are attracted to the tax deductions with the Section 79. Secondly, advisors want to make a sale. Most probably really do not care about the well being of the business owner as long as a sale is made or the life insurance agents have not scrutinized the return of investments of other retirement strategies.

Business owners need to be informed so they can make educated decisions regarding these plans. From a financial standpoint, these plans do not provide much in terms of financial benefits, asset protection, or wealth building for retirement. In many cases, an agent will suggest these plans because they know the owner is looking for tax deductions. However, this does not mean that the plans themselves are overly beneficial – there are better ways to get tax deductions. Life insurance agents will seldom take the time to crunch the numbers and present the true breakdown to a client. Life insurance agents should be comparing the Section 79 plans with other policies.

This is why business owners have to be aware of what they are buying into. Instead of getting involved with a Section 79 plan, most small business owners would reap more benefits from paying the business income taxes and then funding a good EIUL (Equity Indexed Universal Life) to generate wealth in retirement.

Section 79 with good tax deduction vs. After-tax purchase of a Quality Cash Value Life

Let’s compare the returns of a Section 79 which has an initial good tax deduction with investments of funds of after-tax income into a good life policy. A proprietor buys $150,000 in premiums to a Section 79 Plan and he is 45 years of age and will be paying the premium for a period of five years. The proprietor will then borrow money from the life policy when he is between the ages of 65 and 84. We will compare this scenario with another option, which is for the proprietor to pay the taxes and use money to fund a good cash value life policy for a period of five years. The proprietor will then borrow from the life policy from ages 65 to 84.

Section 79 loaned money that is tax free annually = $125,469

Quality policy loaned money annually = $187,626

Is the difference in the amounts actually worth the 40% deduction for the Section 79 Plan? Of course not. It would actually be a very poor choice on behalf of the business owner if he decided to use a Section 79 plan after seeing the math.

To see a breakdown of the financial calculations of the Section 79 plan, please Section 79 income.

Pro or Con? Section 79

Agents will try to convince business owners into using a Section 79 Plan by focusing on the deduction. Unfortunately, many business owners will not look into these plans and calculate the numbers before they jump right in. Keep in mind that life insurance advisors are incentivized to make money, which means they want to sell insurance. They really must have not calculated the numbers or do not care if these plans are the right or wrong path for the owner. This is why it is essential for business owners to be aware of these plans and ask for full disclosure from the advisor before making any decision.

Contact Estate Street Partners to discuss how we can help you plan for retirement and what is the best investment to maximize your retirement income.

Read Part 2 on: Section 79 Insurance

In Retirement planning, variable Loans are common options in life insurance policies and are used when people are looking to borrow money from their policies. However, there is no way to determine whether the money left in the policy will continue to make money or if an individual will be forced to obtain funds to cover the interest charges for the loan. There are other options, including a policy that credits 140% of the annual returns of the S&P 500.

Variable Loan Options when Planning for Retirement

Example of Equity Indexed Life Insurance Return

Let’s say an individual buys an Equity Indexed Life Insurance (EILI) and the growth that is in the policy is correlated to the S&P 500. Should the year produce a return of 11% on a policy that charges an interest rate of 5%, the policy holder would actually make money by borrowing from their policy.

Things change if the S&P 500 has a negative return for the year. In this case, the interest rate would remain at 5%. If the S&P 500 does not perform better than the interest rate, the cash that was left in the policy would be used to pay the cost of the interest on the loan. This results in the policy holder losing cash value inside the policy.

Example of Variable Loans Return

If the policy holder had been using a variable loan when the S&P 500 returned a negative amount, it is possible the individual would have heard from the insurance company stating that there are not sufficient funds in the policy to cover the cost of the interest. Another possibility is that the policy would lapse.

Insurance Companies Show Variable Loans Instead of a Wash Loan

Unfortunately, individuals who purchase a policy that has the option of a variable loan often do not understand why this option even exists. These policy holders only look at the amount that can be borrowed from the policy and do not consider the ramifications.

The problem is that the software that is used to display the loans’ forecast will default the interest on the loan. They will display the numbers for a variable loan instead of a wash loan. This can include a spread of 1-2%. The reason the variable loan is used in the software calculations is because, historically, the S&P 500 has always performed better than any interest rates by at least 2% each year. Even though this is the average, there is always the possibility that the S&P 500 could underperform. It happened in the 1980s where interest rates were over 15% at some point. During times like that, the policy holder would be in a world of hurt with a variable loan if the S&P 500 took a dive or went flat over an extended period of time.

Disclosure of a Variable Loan and Wash Loan

If you are even contemplating buying a policy with a variable loan option, you must make sure you have a complete understanding how the loan will work if you ever have to borrow against your policy. Make sure to get an output of the variable loan as well as a wash loan and take the time you compare the numbers. Even if the agent pushes a variable loan option, you should be aware that you have two choices available; the variable loan and a wash loan. Many agents will not disclose this information, so it is up to the individual to do some homework.

Equity Indexed Life Insurance Can Credit 140% of the S&P 500 Returns Every Year

It has been mentioned that some EILI policies will credit the policy holder with 140% of the return of the S&P 500 for the year. This is the type of policy that is preferred when dealing with a variable loan. To help you understand why this is a good choice, let’s set an example to make things clearer.

We will assume that a policy has an interest rate of 5%. Most policies will be pegged to the returns of the S&P 500, which let’s assume in a particular year is around 3.7%. In this case, the policy holder will be negative 1.3% because the return of the S&P 500 is less than the amount of the interest. This is why policy holders would benefit more from a wash loan. It protects them from the possibility of the S&P 500 underperforming the interest rate and reduces the chances of losing money when taking a loan on a policy. If the policy holder had chosen a wash loan, the policy would be credited with 140% of the S&P 500 returns and the individual would have earned 5.2% in the policy instead of losing 1.3%.

To change the numbers, let’s say the S&P 500 returned 2.5% for the year. The individual would then be negative 2.5% if the interest rate remained at 5%. However, if the individual had a policy that credited 140%, the loss would only have been 1.5%. This can amount to a huge sum of money.

Added protection is awarded to a individual when they have the 140% credit. At some point, the S&P 500 will underperform. There is never any way to know when this will happen, so in order to protect against huge losses, individuals would benefit from choosing a policy with the extra credit. In addition, the same type of policy will provide a no lapse guarantee for individuals over the age of 65.