The Section 79 Plan Catch

Section 79 Catch

The Section 79 Plan Catch

The Pitch

The basic pitch behind section 79 plans is the opportunity to buy cash value life insurance using pre-tax dollars. The returns on cash value life insurance tend to be low, but if you could buy them with pre-tax dollars and borrow money from them tax-free but not interest free, the after-tax returns start to look a lot more attractive. The insurance agents sells it like this:

How would you like a retirement plan where you get:

1) An upfront tax deduction

2) Tax-protected growth,

3) Tax-free income in retirement, and

4) Don’t have to pay for an employee match into the plan?

How It Works

Section 79 is the section of IRS Code that encourages employers to offer life insurance along with health insurance to their employees. The rules are that you can deduct the premium cost for $50,000 of group life insurance for each employee. And what most companies do with that is offer $50,000 of free term insurance to their employees. It makes the employees think the employer cares about them, even though they probably need 10, 20, or perhaps 50 times as much insurance. The benefit is much cheaper than offering health insurance to the employees. In fact, premiums might only be $100 per person per year. That’s what a 30 year old healthy male can buy $50K in 5 year level term insurance for. So the employer gets to offer the employee a tiny amount of life insurance and write it off as a business expense. Sometimes, the employer will even let the employee buy a little bit more of the insurance, but any amount above and beyond the premiums due on the first $50K is fully taxable to the employee.

However, there is no rule that says the insurance offered has to be term life insurance. That’s where the insurance agents figure there’s an opportunity to sell some cash value life insurance. Of course, this is also where all the complexity comes in. A general truism in personal finance is that the more complex the product, the better it is for the guy selling it and the worse it is for the guy buying it. So when things start getting complicated, that’s the time to really beware. Of course there is a catch. In fact, there are quite a few catches…

The Deduction and Paying Taxes on Phantom Income

If the employer just buys all the employees a $50K term policy, the entire cost of that is probably deductible. If he decides to instead offer a permanent life insurance policy, the entire cost is no longer deductible. But, if properly designed, it’s possible that 20-40% of the cost of the premium can be deductible to the employee (the entire premium is deductible to the corporation.) That’s catch #1. Remember the insurance agent offered the opportunity to buy whole life insurance with pre-tax dollars. It’s pre-tax to the corporation, but not to you as the employee. You only get to buy 20-40% of the premium with pre-tax dollars. The rest has to be bought with post-tax dollars.

To make matters worse, you have to pay the taxes on that benefit from other income because this income to you is “phantom income” because you never saw it. So the employer gives you this policy (let’s say $100K premium per year), then you have to pay taxes on $60-80K of it (probably $20K or so) without ever actually getting the $100K with which to pay the taxes. It’s a bit like the phantom income issue with TIPS in a taxable account. That’s catch #2.

Scaring the Employees

Just like with a 401(k) or other typical employer-offered retirement plan, you can’t discriminate against your employees. If you want to buy yourself a whole life policy, you have to offer it to your employees. And that does get really expensive. However, the employees can choose not to participate. Why would they choose not to? Well, you have to scare them into not taking it, because if someone else is going to pay all the premiums, I’ll sure as heck take the policy.

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