Tax-Efficient Planning Ideas for a Post-COVID-19 World

Defined benefit plans can have substantially higher annual contribution limits than other IRS qualified retirement plans. According to the IRS, the 2020 annual contribution limit is

1. 100% of the participant's average compensation for his or her highest three consecutive calendar years, or
2. $230,000 for 2020 ($225,000 for 2019)

The benefits don’t stop with the higher annual contribution limits. While there are additional filing requirements, the IRS writes:

If you establish a defined benefit plan, you:

• Can have other retirement plans
• Can be a business of any size

PPLI, available to accredited investors, as defined by the SEC, is life insurance similar to retail variable universal life insurance (VUL) with some major differences. It has the tax advantages of life insurance, more investment possibilities than standard VUL, and offers advantages that HNW clients often need. Mary Ann Mancini of Loeb & Loeb LLP in Washington writes, “It is designed to appeal to high net worth individuals who are interested in funding the policy with a large up-front premium payment and want to achieve an advantageous investment return for such premium amounts transferred into the policy.

My firm, Pfleger Financial, is one of the leading experts in the administration and structuring of PPLI. We have written the following:

High net-worth individuals utilize private placement insurance so as to protect different asset class investments from period taxation. Such accounts seek to improve creditor protection, reduce reporting requirements for international financial institutions, increase post-tax returns, reduce K-1s, enhance charitable donations, and protect international non-grantor trust assets from DNI. Under the most common circumstances, the cost of private placement insurance is significantly lower than income taxes otherwise paid on investment gains. Private placement insurance requires continuous administration and customization.

HNW clients have different investment needs than those of the average investor. Investment diversification may include hedge funds, funds of funds and other alternative investments. The problem is that these investments sometimes have much higher tax rates than traditional investments held for a long time period. PPLI utilizes the tax advantages of life insurance to reduce the higher tax rates of alternative investments. Investments held in a PPLI benefit from tax-free growth for as long as they remain in the policy. Also, as the assets are held in an insurance policy, they are separated and protected from personal liabilities.

The Excel tables below show the advantages of a PPLI, especially for residents of high-income tax states. This table doesn’t consider the possible federal and state estate tax savings that a PPLI can achieve, which as an insurance product, can be substantial. For this table, $500,000 is invested at the beginning of the year for 10 years. Annual returns are 5%. The capital is reinvested at the same 5% rate every year. Annual income taxation is 50% for the taxable account and the PPLI has an annual insurance fee of 1.5% of the capital of the PPLI.

Taxable Account PPLI

Yr.	Capital at Beginning of Year	Return on Capital	Annual 50% Tax (Federal and State)	Year End Net After 50% Tax		Capital at Beginning of Year	Return on Capital	1.5% Annual Insurance Fee on Capital	Year End Net After 1.5% Annual Insurance Fee
1	500,000	25,000	12,500	512,500		500,000	25,000	7,500	517,500
2	1,012,500	50,625	25,313	1,037,813		1,017,500	50,875	15,263	1,053,113
3	1,537,813	76,891	38,445	1,576,258		1,553,113	77,656	23,297	1,607,471
4	2,076,258	103,813	51,906	2,128,164		2,107,471	105,374	31,612	2,181,233
5	2,628,164	131,408	65,704	2,693,868		2,681,233	134,062	40,218	2,775,076
6	3,193,868	159,693	79,847	3,273,715		3,275,076	163,754	49,126	3,389,704
7	3,773,715	188,686	94,343	3,868,058		3,889,704	194,485	58,346	4,025,843
8	4,368,058	218,403	109,201	4,477,259		4,525,843	226,292	67,888	4,684,248
9	4,977,259	248,863	124,431	5,101,691		5,184,248	259,212	77,764	5,365,697
10	5,601,691	280,085	140,042	5,741,733		5,865,697	293,285	87,985	6,070,996
11	5,741,733	287,087	143,543	5,885,276		6,070,996	303,550	91,065	6,283,481
12	5,885,276	294,264	147,132	6,032,408		6,283,481	314,174	94,252	6,503,403
13	6,032,408	301,620	150,810	6,183,219		6,503,403	325,170	97,551	6,731,022
14	6,183,219	309,161	154,580	6,337,799		6,731,022	336,551	100,965	6,966,608
15	6,337,799	316,890	158,445	6,496,244		6,966,608	348,330	104,499	7,210,439
16	6,496,244	324,812	162,406	6,658,650		7,210,439	360,522	108,157	7,462,804
17	6,658,650	332,933	166,466	6,825,116		7,462,804	373,140	111,942	7,724,002
18	6,825,116	341,256	170,628	6,995,744		7,724,002	386,200	115,860	7,994,342
19	6,995,744	349,787	174,894	7,170,638		7,994,342	399,717	119,915	8,274,144
20	7,170,638	358,532	179,266	7,349,904		8,274,144	413,707	124,112	8,563,739

The wealth producing advantages of the PPLI start in the first year and only increase with time. After twenty years, the Year End Net of the PPLI is $8,563,739, roughly 16.5% more than the taxable account balance of $7,349,904. As with standard VUL, the client can easily access his or her money in a PPLI. Investment diversification is a mandatory requirement for a PPLI, which only benefits the client.

In conclusion, nobody knows what the post-COVID-19 world will bring. It could easily include higher taxes to pay for the health and economic government actions to combat the virus, especially if Republicans lose the November elections. In 2019, the combined federal and state top marginal income tax rate for the 10 states with the highest state income tax was, according to TurboTax, between 50.3 (California) and 44.65% (Wisconsin). With the top federal marginal income tax rate at 37%, a 10% increase of roughly 4 percentage points could produce increased interest in finding ways to reduce the tax drag on investments. A larger increase could produce a stampede to tax efficiencies as investors who had anticipated a low tax environment are faced with either change strategies or paying higher taxes. Municipal bonds yields are low and include investment risks. Tax-efficient investment structures that maximize the growth of American’s hard-earned income and wealth are the solution.

These wealth management solutions can offer many advantages but may be complex to implement and maintain. If you have little experience with them, it’s best to reach out to other licensed financial professionals for help. Nobody can be an expert in everything.

John H. Morse works for a Registered Investment Adviser and has worked in finance for close to 40 years. For more information on these subjects, contact John at [email protected]

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