New life insurance strategies.

Tax provisions, particularly the Omnibus Budget Reconciliation Act of 1993 (OBRA), have enhanced permanent life insurance's appeal and the planning strategies it facilitates. One result of OBRA is that life insurance is gaining more attention as a savings and investment vehicle. Unlike other investments, life insurance provides tax-free death benefits; distributions are taxed on a first-in, first-out basis and tax-free loans are available at minimum cost. To help CPAs advise their clients, this article explores some individual and corporate life insurance planning opportunities.

THE ADVANTAGES OF VARIABLE LIFE

With tax brackets increasing, (OBRA raised the top individual tax rate to 39.6%), variable life insurance deserves another look from CPAs and their clients. Whether or not variable life insurance makes sense as a retirement savings vehicle depends on the insured's health, the policy owner's proximity to retirement and the policy's design.

Variable life is a tax-efficient way to generate retirement income. Tax-free income can be taken as withdrawals up to the insured's cost basis in the policy and thereafter through policy loans. Loan interest also can be borrowed from the policy. When an insured dies, the loan is repaid with the tax-free death benefit. Note: Care must be taken not to surrender a policy before death if loans and withdrawals exceed total premiums paid. Any excess will be taxed as income.

Variable life insurance's only disadvantage as compared with other savings vehicles (exhibit 1, below, compares some of the characteristics of alternative investments) is that mortality costs are charged against cash values. These costs can be mitigated by minimizing the policy's death benefit, based on guidelines in the Tax Equity and Fiscal Responsibility Act of 1982 and the Tax and Miscellaneous Revenue Act of 1986. (While the calculation is complicated, it is built into most insurance carriers' product illustration software. Nevertheless, in many cases mortality costs actually are covered by the tax savings from deferred interest.

THE POPULARITY OF SPLIT-DOLLAR PLANS

Split-dollar insurance plans generally are used to provide permanent insurance protection and sometimes post-retirement income. Although these plans have many variations, the most common is the collateral assignment approach. An employer pays the annual premium, and the executive, who owns the policy, collaterally assigns to the company a part of its cash value and death benefit that is equal to its cumulative premium payments. Remaining cash values and death benefits belong to the executive (or his or her beneficiary). Employer-paid premiums are not tax deductible or reportable as income by the executive. However, under revenue ruling 66-110, 1966-1 CB 12, executives must annually report as taxable income a small economic benefit based on the lower of P.S. 58 table rates or alternative term insurance rates applied to his or her portion of the death benefit.

Typically, at a designated future date (usually retirement), executives withdraw cash value to repay the corporation for cumulative premium payments. Referred to as a "rollout," the collateral assignment is released at this time, P.S. 58 income ends, no further premiums are payable and executives can

* Continue coverage at the preretirement level.

* Reduce coverage and withdraw any cash value.

* Surrender the policy for its cash value.

At rollout, a corporation's reimbursement is income tax-free as a return of policy basis. Taxation of the policyowner's cash value, however, is unclear because the Internal Revenue Service has not issued a ruling. Some practitioners maintain the cash value is taxable to the policyowner, others believe it is only taxable if the policyowner surrenders the policy or withdraws cash value. With a CPA's advice, policies can be designed around this gray area, based on the parties' objectives.

After OBRA, split-dollar insurance plans have become more popular because

* It is the first time since 1986 that corporate income tax brackets are lower than individual tax brackets (34% versus 39.6%). This feature is key because of the nondeductibility of corporate premiums under split-dollar plans.

* Split-dollar plans can provide tax-free retirement income through policy loans.

* The executive's reportable taxable income is insignificant compared to the premiums paid.

THE DEMAND FOR EXECUTIVE GROUP TERM CARVE-OUT (GTCO) PLANS

Under Internal Revenue Code section 79, the cost of up to $50,000 of employer-paid group term life insurance coverage is tax-free. Excess coverage is taxed using rates found in section 79. Executive GTCO plans replace group term insurance above $50,000 with individual permanent life insurance policies for some executives. Policies may be funded under split-dollar, executive bonus or death--benefit-only arrangements; after OBRA, split-dollar is the most tax-efficient approach. Exhibit 2, at left, compares group term insurance to some alternatives.

Split-dollar GTCO plans offer many advantages over conventional group term. From the insured's perspective, GTCO coverage extends beyond retirement, while group term coverage usually either is reduced or terminated. Unlike group term, GTCO policies are portable and coverage amounts are not subject to nondiscrimination rules. Reportable taxable income is based on P.S. 58 rates or alternative term rates, which are much lower than section 79 group term rates. At retirement, most split-dollar policies are designed to roll out and P.S. 58 income ends. Section 79 income continues as long as group term coverage is in force.

For example, for a male age 55 the reportable income for $500,000 of group term is $4,050 using section 79. Under a split dollar arrangement, it would be only $1,020 (based on Pacific Mutual Insurance Company's alternative term premium rates).

From a corporate standpoint, split-dollar GTCO plans can have minimal effect on the balance sheet. Although premiums are not tax deductible, they are recoverable, either at rollout or at the executive's death. Until cash values catch up with cumulative corporate premiums paid (usually within 5 to 10 years), the balance sheet impact equals the cash value minus the corporate premium advances. The only corporate cost is the time value of money; with group term, corporations sustain the aftertax cost of the term insurance premium for every year the coverage is in force.

OBRA spurred demand for GTCO plans primarily because of increased individual income tax brackets and section 79 income. Such plans also provide a means of supplementing reduced qualified retirement plan benefits--cash values can be borrowed tax-free to provide additional income.

THE NEED FOR NONQUALIFIED EXECUTIVE BENEFIT PLANS

Highly paid executives and their employers have used insurance-financed nonqualified executive benefit plans as retirement planning vehicles for years. Both defined contribution and defined benefit plans are established on a nonqualified basis to enhance a corporation's existing qualified plans.

Deferred compensation plans. The most common nonqualified defined contribution plan is a deferred compensation plan. Pretax deferral and tax deferred growth of contributions allow executives limited by the pretax dollars they can contribute to 401(k) plans to defer additional pretax earnings. Since OBRA, many executives are using every opportunity to defer current income. Exhibit 3, above, illustrates why participants choose to defer income pretax instead of receiving and investing aftertax earnings themselves. In the example, aftertax or personal investments must earn 15% pretax to produce the same aftertax annual retirement benefit generated from the deferral plan earning 9% pretax.

With the popularity of variable life insurance and deferred compensation plans, variable deferred compensation plans, offering executives investment choices similar to those they enjoy in 401(k) plans, are common. Interest credited to deferral accounts can be tied to the performance of a variety of funds available through variable life insurance contracts.

Supplemental executive benefit plans (SERPs). Nonqualified defined benefit plans--usually called SERPs--are adopted by corporations to allow executives affected by IRC section 415 limits on annual defined benefit plan payouts to receive the benefits promised by a corporation's qualified pension plan. The 1995 section 415 limit is $120,000.

Many companies not only offer pure "excess plans"--which make up only for pension benefits lost due to section 415--but also offer supplemental plans that restore benefits lost due to the OBRA-imposed $150,000 compensation cap. The $150,000 limit expanded the number of executives who need SERPs and increased future SERP benefits for many existing participants. Exhibit 4, page 44, illustrates the impact the new limit has had on the proportion of executive retirement income generated by qualified and nonqualified plans. Before OBRA, 94% of an executive's retirement income was provided through qualified plans; 6% was provided by SERPs. Since OBRA's passage, 59% of retirement benefits are provided through qualified plans, while 41% are provided by SERPs.

Life insurance is an extremely efficient way to finance executive benefit plans because earnings are tax deferred, death benefits are tax-free and unrealized gains on insurance cash values are booked annually. With increased corporate tax rates, the amount of insurance a corporation needs to recover the cost of nonqualified plans on a net present basis has decreased.

NEW OPPORTUNITIES

OBRA created new opportunities for individual and corporate retirement strategies. Coupled with the inherent tax advantages associated with both traditional and variable life insurance, CPAs can use these new retirement planning opportunities to maximum advantage in advising clients.

RELATED ARTICLE: MARTIN J. SATINSKY: ESTABLISHING A PROFESSIONAL RELATIONSHIP

Some might consider Martin J. Satinsky an expert on relationships between CPAs and life insurance agents. He and a colleague from the life insurance industry frequently make presentations to agents to help them deal professionally with accountants as part of a financial planning team. Satinsky, a CPA and attorney, has provided tax and financial planning services for over 20 years. A former tax partner with Coopers & Lybrand, he now has his own practice in Philadelphia.

With most clients, Satinsky says he is the one who raises the need for life insurance. "Because I am doing a full financial plan for them, as I analyze their resources and goals, insurance comes into play as a tool to fulfill one or more of those goals." Satinsky tells clients there is a need for insurance but rarely goes into what products they should buy. He helps them with amount, ownership and beneficiary designations and recommends how long coverage should be in place. At this point Satinsky and his client are ready to go to an insurance professional and say, "Here's what we are looking for--now you tell us what product best fulfills this need."

Only about 10% to 15% of the time do clients come to Satinsky with specific insurance proposals. While he says he hasn't prevented any real disasters, Satinsky does get clients to take a step back and decide what they want to accomplish with insurance.

Satinsky says most clients have dealt with insurance professionals but few have someone they really trust. "I always ask if they have someone they want me to work with, but most ask for a referral." Satinsky works with about a half dozen agents regularly and another 20 or 30 less frequently. He says, "The people I know treat me as the client, and that's the key in my mind for a CPA-financial planner representing a client. Agents have to understand that I am the client's representative--the key contact." Satinsky believes it's critical clients have that kind of representation. "Agents have to treat me professionally and respond to what I'm looking for. I treat the agents professionally as well. That's what makes it work--an understanding that it's a professional relationship."

For CPAs less experienced in insurance, Satinsky recommends they "decide how far into the insurance evaluation process they want to go and set some limits." For example, Satinsky says, while he is capable of giving his clients investment advice, he prefers not to. "In insurance, I have more experience and can act as a filter." Satinsky suggests CPAs who do not have his comfort level with insurance take the time to find one, two or at most three agents in whom they have total confidence.

KRISTIN BARENS is a vice-president of Mullin Consulting, Inc., in Los Angeles. BETH LANG, CLU, is vice-president of operations and planning for Gateway Financial Group, Inc., in Pittsburgh, Pennsylvania. Mullin Consulting and Gateway Financial both are members of the M Financial Group.