October 16, 2018

Watch out: 419e Plans can cause Reduced 401(k) Plan Contributions

Watch out: 419e Plans can Cause Reduced 401(k) Plan Contributions

It’s certainly not every day that I learn something new, but  recently I had one of those days.  Because 419 plans are still a “hot” topic in the insurance, financial, accounting and legal communities, I believe it is important for me to continue to keep you informed on this much abused topic.

Many of you read with interest the newsletter from a few weeks ago where I discussed using VEBAs as a nice year end income-tax planning tool for highly compensated business owners who have maxed out their pension plans and are looking for additional deductions.  (If you did not read the last week’s newsletter on VEBA and would like to or would like the PowerPoint which went along with the VEBA Webinar, please e-mail Email Us“>Email Us and indicated that you would like a copy of the newsletter and/or the PowerPoint presentation.)

My stance on single employer VEBAs and 419e plans is that they are a misunderstood tool by both the client and the advisors selling them.  Everyone touts them as a terrific way to buy life insurance in a “tax-deductible” manner where the death benefit can pass income and estate-tax free if the beneficiary designation is setup correctly. That is true and it can be a nice benefit, but what is not talked about much in the industry are the table 1 costs that the client must recapture every year.

When a client is younger, this recapture cost is not significant. However, when a client nears age 60-65 the cost becomes significant.  At age 45, a client who has a $2,550,000 death benefit from a policy inside a 419 plan has to recapture as imputed/phantom income $4,500.  If the policy stays in the 419 plan until the client reaches 69 years old (well before the assumed date of death), the total recaptured/imputed phantom income would be $411,500 over the life of the plan.  This cost is almost never discussed with the client.

For those of you that are selling 419 plans of any kind, do you discuss this with your clients?  For a more detailed summary on the phantom income issue with 419 plans and how to calculate that income, please e-mail Email Us“>Email Us and a summary will be provided to you.

Reduction in 401(k)/defined contribution plan contributions

Many of the advisors reading my newsletter had clients take corporate deductions for contributions to 419 or VEBA plans at the end of 2006. Many of those plans included an element of post-retirement medical benefits for the employees (which is a great idea). The problem, as you will read, is that IF a client is “maxing-out” their 401(k)/Profit Sharing plan and contributed to a 419/VEBA plan where “post-retirement” medical benefits were included, the client is probably aware that he/she will receive NO deduction for the 419/VEBA contribution. See below for more information.

If you go out into the marketplace and look at single employer 419e and single employer VEBA plans (or even multiple employer plans), you will notice that most offer some kind of “other living benefit” with their plans (vs. a death benefit only plan).

I like the sale’s pitch which goes something like the following:

Advisor: Dr. Smith, would you agree with me that you will have thousands of dollars in medical bills after you retire?  (For example: drug costs and other long-term care costs).

Dr. Smith: Yes, my mother and father (ages 68 and 72) paid nearly $10,000 last year for such expenses.

Advisor: How did your parents pay for their expenses?

Dr. Smith: They had no insurance coverage so they paid for them out of their checking account.

Advisor:  Would you like me to show you a plan where you could take a business deduction through your medical practice today where the money contributed to a plan would grow tax-free and where you could take the money out of the plan completely tax-free for post-retirement medical expenses?

Dr. Smith: Yes, that sound like a great idea……

Again, I like the above sale’s pitch and the benefit to the client.

Without giving a history lesson on 419 plans, what you need to know is that the IRS hammered the use of 10-or-more multiple employer 419 plans.  They were hammered so hard that it nearly shut down their use nationwide. The new IRS regulations on 419 plans however, did not cover single employer 419e or VEBA plans.  Therefore, most of the multiple employer plans were frozen or shut down and everyone started coming out with single employer plans.

That’s great, we need to do what we need to do in order to help our clients, but what I didn’t know and my guess is what 99.9% of the readers of this newsletter don’t know is that there is a setoff against the employee’s 401(k)/profit sharing plan contributions for every dollar allocated to post retirement medical benefits purchased in a single employer 419e or VEBA.  This was not an issue with 10-or-more multiple employer plans.

Why is this important?  Because most people pitching single employer plans are pitching them with some element of post-retirement medical benefits (which is a good thing).  The problem is that no one is disclosing the fact that there is this setoff.

It can still be a powerful sale’s pitch:  Advisor:  Dr. Smith, I want to remind you that every dollar you contribute to your 401(k) plan is going to be income-taxed some day.  If, however, you allocated $10,000-$20,000 to a 419e or single employer VEBA plan, that money would still grow tax-deferred like a 401(k) plan, however, when the money comes out of the plan for post-retirement medical benefits, the money comes out income-tax free.  Dr. Smith, wouldn’t it make sense to allocate some dollars to a 419e or single employer VEBA plan?  Most clients will say yes.

One last caveat, the setoff issue does NOT apply to defined benefit plans. This brings up a lot of other planning issues which I cant’ get into today, but you do need to know that only defined contribution plans have the setoff issue.

I wish I had more space in this newsletter to tell you why I believe if your clients are only interested in the post-retirement medical benefits, they should be using single employer VEBAs funded solely with equity indexed annuities, but I don’t. If you would like information on annuity only VEBAs with NO phantom/imputed/recaptured income costs, please e-mail Email Us“>Email Us for a summary.

I’d like to thank John Lalonde of HealthCare Annuity Plus, LLC as well as Greg Bertsch, JD of Duggan and Bertsch Law for their helping clarify the setoff issue with single employer and 419e Plans.

Roccy DeFrancesco, JD, CWPP™, CAPP™

Founder

The Wealth Preservation Institute

Circular 230 disclaimer: To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in this communication (including any attachments) is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter addressed herein.