‘Split Dollar’ Solution to Retirement Problem

If you own a business with a 401(k) plan, ask yourself this question: Do you know that your employees will probably get far more out of it than you will?

Rank-and-file employees get a big bang for their buck in a 401(k). For many business owners, however, 401(k) plans don’t do much to keep body and soul together in retirement--and the higher their pay, the bigger the problem.

You can, however, solve the problem for yourself--and for your highly paid managers, who confront the same difficulty--with a sophisticated insurance package paid for, in large part, with company dollars.

How? Let’s explore the problem first.

Federal pension law limits your tax-deductible 401(k) contributions to $10,000 a year. Assuming contributions of $10,000 over 20 years and earning, say, 10% annually, you end up with a nest egg of roughly $630,000. At a return of 5% a year, that gets you $31,500 a year in retirement income, all of it taxable at ordinary rates.

That’s not bad if you assume a pre-retirement income of $50,000. At that level the nest egg replaces 63% of pre-retirement income, before taxes.

But if, as the owner of the business, you now take home $200,000 a year, and you expect to need $150,000 to stay happy in retirement, you’ll get less than 16% of that sum from your 401(k) nest egg.

In plain English, you need to turbocharge your own savings plan, along with those of your highly paid managers, because your 401(k) plan skews things toward your rank-and-file employees.

Life insurance agents do a good business offering a solution called split dollar life insurance, paid for in large part with business dollars. As explained in this space last week, split dollar life insurance can go a long way toward guaranteeing that a family business outlives its founders by giving the second generation a source of funds for estate taxes.

It can also solve the problem of the skewed 401(k) plan, once again using business dollars. Indeed, properly structured, split dollar life insurance can even yield a substantial retirement income free of income taxes, giving you a very big bang for your buck when saving for your own retirement.

As the name implies, split dollar life insurance splits the premium, the cash value and the death benefit between the individual being insured and the business. More specifically, part of the premium comes from your own pocket, part from your business. Similarly, some of the cash value in the policy belongs to you, some to your business, and in the event of your death, some of the death benefit goes to your family, some to the business.

Let’s assume you’re 43 and in good health. You buy $1 million in split dollar insurance on yourself for premiums totaling roughly $22,000 a year. Of that sum, your business pays about $20,500 in the first year. You pay the rest, $1,500, out of your own pocket in the first year and an increasing amount in each year thereafter, rising to roughly $15,000 the year before retirement.

To limit the damage to your own wallet, your company gives you a bonus equal to your part of the premium, with the result that what actually comes out of your pocket is the tax on the bonus.

At age 65 the cash value on this policy exceeds $1.1 million--a nest egg capable of throwing off between $50,00 and $100,000 in income every year, depending on how much you need. And you take this money in the form of a policy loan free of income tax.

“What this gives you is a big bucket of money at age 65,” says Joel Kabaker, a Northwestern Mutual Life agent with offices in Sherman Oaks.

“If you have money in this bucket, plus more in your 401(k) bucket, plus more in the equity in your house, plus more in your own personal savings and in your other investments, your only problem is to decide which bucket to take money from to make your retirement very comfortable.”

You can’t strip all the cash out of the policy, Kabaker says, because that strips the policy of a death benefit too--and if that happens, you lose the tax benefits. But you can take out enough to keep body and soul together.

“It’s the agent’s job to make sure you don’t do that,” Kabaker says. “If you take too much out of the policy, you can’t sustain the plan as a life insurance policy with all the tax benefits that go along with it. You have to keep some amount of life insurance in force until you die, even if it’s only a minimal amount.”

Recent reforms in tax law make it difficult for highly paid people, among them many business owners, to set aside enough money to maintain their lifestyles after retirement, Kabaker says. A 401(k) plan goes a long way toward making the disciplined rank-and-file employee comfortable in retirement, but highly paid people must use other options.

“A split dollar life insurance policy with a high cash value can solve this problem by providing a pool of money that grows tax deferred and then may flow into the hands of the executive, again without taxation,” Kabaker says, “and it’s the business, not the pocketbook of the individual, that bears the cost.

“To many executives who face a big tax bill every year, this can provide real leverage.”

Columnist Juan Hovey may be reached at (805) 492-7909 or via e-mail at jhovey@gte.net.