In mountain climbing, success is not simply about making it to the top. It includes coming back down the mountain. Likewise, retirement planning should not focus solely on accumulation.
The focus should be on providing sufficient net income for the client and his loved ones when he is no longer working. Rather than measuring a client's retirement preparedness by the amount he has saved, you may want to measure how much net income is available to meet his needs -- and this may include providing for his family in the event that he dies before reaching retirement age.
A sustainable retirement should include a plan for unexpected death, a plan for having access to savings when needed and a plan to reduce the potential impact of taxes on retirement income. To ensure that your client and his family are protected all the way back down the mountain, his retirement plan should be distribution-focused.
The trouble with accumulation-focused retirement plans
Most of today's retirement planning is accumulation-focused: the goal is to reach a targeted amount of savings prior to reaching retirement age. Accumulation-focused plans can be either qualified retirement plans or nonqualified retirement plans. While there are different requirements and limitations for the various plan types, both qualified and nonqualified retirement plans share similar planning obstacles.
Obstacle #1: Protection in the event of an early death
Retirement planning is not only about the individual; it is also about those loved ones who rely on him for support. In this sense, retirement planning is an extension of income planning -- you work both to provide for your loved ones now and to provide for them when you are no longer working. While planning tends to focus on the event of retirement (the voluntary end to working), a plan will be incomplete if it does not provide for loved ones in the event of an early death.
Neither qualified nor nonqualified retirement plans typically provide anything more than accrued benefits if the participant dies early. The family needs the income to provide for daily needs. What happens to them if the client's retirement plan is incomplete at the time of his death?
Obstacle #2: Access to income when you need it
If retirement planning is an extension of income planning (i.e., providing for a family's needs), then the plan should include the ability to access income when those needs arise. But both qualified and nonqualified retirement plans place limits on the client's ability to access income. Unless he meets certain limited exceptions, money he has in qualified retirement plans cannot be accessed without penalty prior to age 59 1/2 .
And money in nonqualified deferred compensation (NQDC) or supplemental executive retirement plans (SERPs) can only be paid out according to the terms of the written agreement. Neither type of retirement plan gives him significant access to income until after he has reached retirement age. What happens if his family has a significant need before he reaches retirement age?
Obstacle #3: Exposure to income taxes
Most qualified and nonqualified retirement plans are built on the model of tax-deferred accumulation. But it is important to keep in mind that tax deferred is not tax avoided; it is simply tax delayed. Whether the client is expecting a promised benefit from a nonqualified retirement plan or he has been accumulating pre-tax funds in a qualified retirement plan, distributions from the plan will be subject to income taxes at the tax rate in effect at the time of distribution.
This raises another question: Do you think income tax rates in the future will be higher or lower than they are today?
How to take a distribution-focused approach
An alternative to the accumulation focus of qualified and nonqualified retirement plans is to consider using a cash-value life insurance policy to potentially increase retirement security. This strategy uses after-tax funds to purchase a life insurance policy, which can be used both for death benefit protection and as a potential source of retirement income.1
Using life insurance as part of a retirement plan has the potential to overcome the obstacles associated with accumulation-focused retirement planning. Life insurance can provide a benefit for a client's family in the event he dies before reaching retirement.2 Distributions from a life insurance policy's cash values may occur at any time prior to age 59 1/2 without a premature distribution penalty from the IRS.
And, provided the life insurance policy is not structured as a modified endowment contract (MEC), the policy owner may be able to receive tax-free income through a combination of policy withdrawals and loans.
Purchasing a cash-value life insurance policy for both death benefit protection and retirement income requires the following steps:
- The insured purchases a life insurance policy insuring his or her life and allocates current after-tax income or savings dollars to pay premiums.
- Premiums are first used to pay policy expenses (e.g., mortality costs, administrative fees, etc.). The remaining portion of the premium (if any) becomes part of the policy's cash value and is credited with interest and/or potential growth as described in the life insurance contract.
- The policy owner may use policy cash values for emergencies or supplemental retirement income through withdrawals and/or loans.4
- At the insured's death, policy death benefits are first used to repay any outstanding policy loans; the balance of the death benefit is paid to the policy beneficiary.
Transitining to a distribution-focused plan
What can you do if the client is already participating in a qualified or nonqualified retirement plan and wants to transition to a distribution-focused plan?
Qualified retirement plans: If the client currently participates in a qualified retirement plan, such as a 401(k) or an IRA, you have three options. One option is to freeze his contributions and instead start making premium payments to a cash-value life insurance policy. A second option is to continue making just enough contributions to get the maximum matching contribution available from the employer.
A third option is to both discontinue new contributions to the plan and to convert funds from his existing plan into premium payments for a cash-value life insurance policy. While he would still have to pay income taxes on the distributions from his qualified plan, he can avoid the 10% penalty for premature distributions by employing "a series of substantially equal periodic payments" under IRC ? 72(t).
Nonqualified retirement plans: Likewise, if the client is currently participating in a nonqualified retirement plan (such as a deferred compensation arrangement) he has the option of discontinuing any contributions he is making to the arrangement at the next election period. However, if he wants to transition the entire plan over to using a cash-value life insurance policy, he will need to get his employer's cooperation and work through the restrictions imposed by the Internal Revenue Code.
The tax treatment of nonqualified retirement plans is governed by IRC ? 409A. Included in the rules for these arrangements is a general prohibition against the acceleration of benefits. According to IRS regulations, the substitution of a new benefit for a benefit promised under a deferred compensation arrangement will be treated as a payment of deferred compensation and may invoke a 20% penalty unless certain requirements are met.3
Cancellation of an existing plan can avoid being characterized as a substitution of benefits if the plan is terminated by the employer, the termination "does not occur proximate to a downturn in the financial health" of the employer, the employer terminates all nonqualified plans of the same type and the employer does not adopt a similar nonqualified plan within three years of the plan termination.4
Because the regulations associated with nonqualified retirement plans are complex, the client and his employer should consult with competent tax or legal counsel before terminating an existing plan or considering a substitution of benefits.5
Now more than ever, a financially secure retirement requires advance planning. As your clients approach their retirement planning, they may want to consider a plan that focuses on protection and distribution rather than limiting their focus to accumulation. Purchasing cash-value life insurance is a simple strategy that allows the client to obtain death benefit protection and a potential source of supplemental retirement income. Using cash-value life insurance offers the potential to plan for retirement while also protecting against the risk of early death, avoiding the distribution limitations of qualified and nonqualified retirement plans, and limiting the potentially adverse impact of increasing income tax rates.
David Houston is an advanced marketing consultant with ING's Insurance Sales Support team. He has experience in estate and business planning, life insurance sales and non-qualified employee benefits. David started his career in private practice with a small Minneapolis law firm and has since worked as an advanced marketing attorney with several major life insurance companies and for a major vendor of bank-owned life insurance (BOLI). He can be reached at (612) 372-5520 or firstname.lastname@example.org.
1. A portion of the policy's surrender value may be available as a source of supplemental retirement income through policy loans and partial withdrawals. Policy loans and partial withdrawals may vary by state, reduce available surrender value and death benefit or cause the policy to lapse. Generally, policy loans and partial withdrawals will not be income taxable if there is a withdrawal to the cost basis (usually premiums paid), followed by policy loans (but only if the policy qualifies as life insurance, is not a modified endowment contract and is not lapsed or surrendered).
2. Proceeds from an insurance policy are generally income-tax free and, if properly structured, may also be free from estate tax.
3. Treas. Reg. 1-409A-3(f)
4. Treas. Reg. 1-409A-3(j)(4)(ix)(C)
5. The ING Life Companies and their agents and representatives do not give tax or legal advice. This information is general in nature and not comprehensive, the applicable laws change frequently, and the strategies suggested may not be suitable for everyone. You should seek advice from your tax and legal advisors regarding your individual situation.