Journal of Financial Planning - September 1999

"Even reputable financial service providers keep trying to turn tax-deductible life insurance premiums into tax-free retirement benefits."

New Versions of Old Tricks: Springing Cash Values

by Peter Katt, CFP, LIC

The perfect retirement plan for high income earners has tax-deductible contributions and tax-free benefits. Financial product marketers devote great energy and effort to designing retirement plans that feature such claimed tax nirvana, reaping the commission rewards of selling them. These marketers are greatly aided in their efforts to design and sell such schemes because the tax code is overwhelmingly complicated. They take the position that if something isn't explicitly prohibited in the tax code, it must be okay.

This results in marketers staying one step ahead of the Internal Revenue Service by creating new versions of old tricks when existing ones have been exposed by the IRS. Also, consumers of such products, tired of carrying such a heavy income tax burden, are easy prey because of the promised tax benefits.

Unfortunately, in the real world, tax-deductible contributions and tax-free benefits don't exist without resorting to deception or fraud. During the past year, I have encountered two variations of the same theme promising consumers these extraordinary tax benefits via the purchase of life insurance. Both involve a concept known as springing cash values. This concept features payments of very large premiums while a policy is subject to favorable tax treatment, then transferring the policy to the insured when the policy appears to have no taxable values, after which the cash values spring to life. Two recent cases will explain springing cash value.

Continuous Group Insurance

Group term insurance premiums paid by an employer are tax deductible, but the insured must report as income the value of term coverage in excess of $50,000. The value of excess coverage is determined by referring to a uniform premium charge published by the IRS. For example, a physician corporation providing a self-employed 38-year-old male with group term insurance of $2,775,000 would pay a deductible annual group term premium of about $3,000, with the employee reporting as income the uniform premium charge of $3,600.

These facts are from a case I reviewed last year, except, the annual group premium was $30,000, not $3,000. My client was told that his corporation could deduct the entire $30,000 as a group term premium. This plan, referred to as continuous group insurance, was marketed as a "nonqualified pension plan." Even though the continuous group premiums were ten times higher than a typical group term premium, the policy didn't generate any cash values.

However, after five years the continuous group policy, having no cash values, would be converted to a permanent policy, owned by the insured, with coverage reduced to $275,000 and premiums of $43,235 for two years, then none. This conversion policy had a guaranteed account value after the first year of $178,000, and after allowing for surrender charges, a guaranteed surrender value of $330,000 and a projected surrender value of $512,000 in the 11th year, representing a guaranteed rate-of-return of 14 percent and a projected ROR of 18 percent!

Obviously this continuous group plan doesn't have two policies at all-only one. The cash values in the so-called conversion policy are generated by the continuous group premiums paid during the first five years. That is, most of the funding for this nonqualified pension plan occurs during the first five years, when the overpaid continuous group premiums are tax deductible and the insured reports as income only a fraction of the actual premium. Then the conversion to a personal permanent policy occurs at a time when the true value is being hidden from the IRS, so the insured reports no taxable income upon conversion.

Clever, except that this isn't group term-it is transparently group permanent insurance because the economic benefits extend beyond one policy year. If a group insurance policy provides permanent benefits, the cost of the permanent benefits is included in the employed insured's income in that year.

The good news for this client is that the IRS never discovered this fraud. The bad news is that the insurance company he bought this continuous group plan from was seized by regulators due to solvency concerns two years after it began, and since he had no right to any cash values until the conversion, he lost $54,000, the difference between the cost of true group term and the continuous group premiums.

VEBA: Pre-Paid Retiree Plan

Another self-employed physician client purchased a similar springing cash values plan that the marketers referred to as a "pre-paid retiree plan," but his plan was wrapped in a VEBA (Voluntary Employee Benefit Association). Large tax-deductible contributions were made to the VEBA, purporting to be a death-benefit-only plan. After a deduction for VEBA administration, all of the annual tax-deductible contributions were used to purchase life insurance, having no value for five years. Then, when the insured converted the VEBA policy to a personal policy, its values magically began appearing. The premiums for this apparent term insurance were about ten times higher than term costs, with the insured only reporting the economic benefit of term insurance (PS 58 rates or the insurance company's term rate). This is the same scam as continuous group insurance. As was the case with the continuous group plan, most of the funding for this "pre-paid retiree plan" occurs during the first five years when the overpaid term premiums within the VEBA are tax deductible, with the insured picking up as income only a fraction of the actual premium. Then the conversion to a personal permanent policy occurs at a time when the true value is being hidden from the IRS, so the insured reports no taxable income upon conversion.

This second client also lost all of his premiums for the first two years because he was with the same insurance company that was seized, but he continued his VEBA plan with two other companies. The IRS noticed what was going on and hit him with tax deficiencies, interest and penalties for several of the years he took the VEBA deductions. Rather than continuing to fight with the IRS in Tax Court, this client decided to settle up; in exchange, the IRS dropped penalty charges. As this is being written, at least one major springing cash value case is in Tax Court. The plaintiffs are trying to focus the arguments on arcane VEBA rules, but this is nonsense since it completely obscures what the real fraud is. The IRS, I think, has figured out that the VEBA is nothing more than a wrapping for the springing cash value scam. I am betting on the IRS.

Not only does the "nonqualified pension plan" carry the risk the IRS will swoop down and recover back taxes, interest and penalties, but because there is such a long time (usually 12 to 14 years) between the payment of very large premiums and having access to the accumulated value, clients run the risk that the insurance company will fold (already happened once), clients will need access to their funds, or their financial situation will have changed such that they aren't able to keep up the very large group premiums, causing the policy to lapse with the loss of all the premiums previously paid.

You may think that these springing cash value plans are being marketed out on the fringe of legitimacy. They are not. The continuous group plan was sold by a pension administration firm who had built up a lot of goodwill over some 20 years, installing and administering qualified pension and profit-sharing plans. The VEBA plan was endorsed by the state medical society, and the financial planning firm selling it was an authorized representative of the medical society. Indeed, the client who bought the VEBA was referred to the financial planning firm by his state medical society. No matter how professional and sincere marketers may appear, there are no plans or products that can legitimately provide tax-deductible life insurance premiums with tax-free retirement benefits.

Reprinted with permission by the Financial Planning Association, Journal of Financial Planning, Volume 12, Issue 8, September 1999.

Peter Katt, CFP, LIC, sole proprietor of Katt & Co., is a fee-only life insurance adviser located in Kalamazoo, Michigan (269.372.3497).