What to do to defer income for this client?

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May 29, 2009 12:44 pm

Here's the situation:

 
Client will make about 75k this year w2 income. Not eligible for 401k at current job yet but was eligible and did contribute elsewhere for the first three months of the year before changing jobs. Not only can he no longer contribute to max out or at least increase, but he's above phase out for a traditional IRA and ineligible (I'm pretty sure) for contribution based on not having an employee account since he was in a 401k at the beginning of the year. (Only a few hundred actually contributed.) 
 
The kicker is that this individual will receive 20k paid as 1099 from a lawsuit by the end of the calendar year. The money will be an "enhancement" to a few grand paid for being the named party in a class action suit against a former employer. Since this is "enhancement" paid as 1099 rather than wages, can I still sock this away in a sep? If not, what would be your other recommendations? The client has explicity stated he will not only not need this money but is also saving about 1k per month so his emergency fund will already be replinished by the time the award is received. Will the 20k be eligible for deferral in some way?
 
I know that in general fees awarded for "pain and suffering" or actual cost of medical procedures can be tax free as a return of principal or exemption in the former case, but not sure about "enhancements" that are not wages. Any thoughts?
May 29, 2009 2:09 pm
xbanker:

Here's the situation:



Client will make about 75k this year w2 income. Not eligible for 401k at current job yet but was eligible and did contribute elsewhere for the first three months of the year before changing jobs. Not only can he no longer contribute to max out or at least increase, but he's above phase out for a traditional IRA and ineligible (I'm pretty sure) for contribution based on not having an employee account since he was in a 401k at the beginning of the year. (Only a few hundred actually contributed.)



The kicker is that this individual will receive 20k paid as 1099 from a lawsuit by the end of the calendar year. The money will be an "enhancement" to a few grand paid for being the named party in a class action suit against a former employer. Since this is "enhancement" paid as 1099 rather than wages, can I still sock this away in a sep? If not, what would be your other recommendations? The client has explicity stated he will not only not need this money but is also saving about 1k per month so his emergency fund will already be replinished by the time the award is received. Will the 20k be eligible for deferral in some way?



I know that in general fees awarded for "pain and suffering" or actual cost of medical procedures can be tax free as a return of principal or exemption in the former case, but not sure about "enhancements" that are not wages. Any thoughts?





An Annuity.

May 29, 2009 4:55 pm

An annuity will defer future taxes, but I don't think it will help for current taxes.

May 29, 2009 5:13 pm

Why is deferring taxes an issue now for this client?  He's not making a whole lot, and taxes have a good enough chance to be higher in the future (when he's making more money).  What about some tax-free options?  Munis, WL insurance come to mind as good options.

May 29, 2009 6:03 pm

Whoops - forgot to add the Roth in there.  Good catch, Ice.

May 29, 2009 6:22 pm
xbanker:

Here's the situation:

 
Client will make about 75k this year w2 income. Not eligible for 401k at current job yet but was eligible and did contribute elsewhere for the first three months of the year before changing jobs. Not only can he no longer contribute to max out or at least increase, but he's above phase out for a traditional IRA and ineligible (I'm pretty sure) for contribution based on not having an employee account since he was in a 401k at the beginning of the year. (Only a few hundred actually contributed.) 
 
The kicker is that this individual will receive 20k paid as 1099 from a lawsuit by the end of the calendar year. The money will be an "enhancement" to a few grand paid for being the named party in a class action suit against a former employer. Since this is "enhancement" paid as 1099 rather than wages, can I still sock this away in a sep? If not, what would be your other recommendations? The client has explicity stated he will not only not need this money but is also saving about 1k per month so his emergency fund will already be replinished by the time the award is received. Will the 20k be eligible for deferral in some way?
 
I know that in general fees awarded for "pain and suffering" or actual cost of medical procedures can be tax free as a return of principal or exemption in the former case, but not sure about "enhancements" that are not wages. Any thoughts?
 
Talk to or tell him to talk to his CPA. You have no business giving tax advice.
May 30, 2009 12:18 am

life insurance retriement plan.  aka overfunded VUL

May 30, 2009 12:31 am
today1:

life insurance retriement plan.  aka overfunded VUL



aka you are an insurance salesman who doesn't know any better....

May 30, 2009 2:20 am
HymanRoth:
today1:

life insurance retriement plan.  aka overfunded VUL



aka you are an insurance salesman who doesn't know any better....

 
What's wrong with an overfunded VUL? You can put it in index funds to keep costs low in the subaccounts, all money that goes in can now grow tax deferred and if USED properly, can be used as an awesome tax free income stream: cost basis out first then loans for after as long as the policy stays in force.  It's also creditor protected.
 
Obviously this isn't for everyone but I recently ran a hypo for these two clients who were both lawyers.  After running the hypo, their cost basis at w/d time was about $100K and their contract value was about 5 or 6 million, can't remember exactly.  If done correctly, the excess over $100K can completely bypass the IRS using the loan method and whatever is left over can pass income tax free to the beneficiaries.  People who complain about this talk about the "costs" of a VUL and I don't know if they every actually CALCULATED how much it costs versus giving Uncle Sam the money.  And with a high likelihood that taxes will go up in the future, I'll take tax free income anyday.  Again, it's not for everyone but it's an awesome tool. 
 
For the record, I'm at an indy OSJ and I didn't learn this from an insurance wholesaler.  I actually learned it from an instructor from the CFP course who happens to be a lawyer and a CFA charter holder who runs his own estate planning and tax services practice.  I'm not a CFP . . .
May 30, 2009 3:18 pm
xbanker:

Here's the situation:



Client will make about 75k this year w2 income. Not eligible for 401k at current job yet but was eligible and did contribute elsewhere for the first three months of the year before changing jobs. Not only can he no longer contribute to max out or at least increase, but he's above phase out for a traditional IRA and ineligible (I'm pretty sure) for contribution based on not having an employee account since he was in a 401k at the beginning of the year. (Only a few hundred actually contributed.)



The kicker is that this individual will receive 20k paid as 1099 from a lawsuit by the end of the calendar year. The money will be an "enhancement" to a few grand paid for being the named party in a class action suit against a former employer. Since this is "enhancement" paid as 1099 rather than wages, can I still sock this away in a sep? If not, what would be your other recommendations? The client has explicity stated he will not only not need this money but is also saving about 1k per month so his emergency fund will already be replinished by the time the award is received. Will the 20k be eligible for deferral in some way?



I know that in general fees awarded for "pain and suffering" or actual cost of medical procedures can be tax free as a return of principal or exemption in the former case, but not sure about "enhancements" that are not wages. Any thoughts?





I wonder how confident this client would be in your advice if he knew you were soliciting basic advice from anonymous people in a chat room? Do you believe you are worth the fees he will have to pay?

May 30, 2009 9:12 pm

if the client has a 10-20 year time frame an overfunded vul works great.  if you run the calculations and factor in taxes it makes sense.   another reason is that taxes are at an all time low right now with only one way to go...up.  if you think its a great idea to keep funding other tax deferred vehicles, like annuites, that you will only have to pay taxes on later you are missing the boat.  it is better to diversify your tax liabilities.  and in reality if you factor in the cost of other programs like variable annuities the costs arent that much different.  do the research and i think you might agree on these types solutions.

May 30, 2009 9:20 pm

"What's wrong with an overfunded VUL? You can put it in index funds to keep costs low in the subaccounts, all money that goes in can now grow tax deferred and if USED properly, can be used as an awesome tax free income stream"



 
Compare this to buying term insurance and investing the difference (BTID).  I happen to think that BTID is a nonsensical topic, but it is exactly what VUL does.  VUL combines overpriced term insurance with overpriced investments.
 
Your line "if USED properly" is huge.   Real life gets in the way causing these products to never be used properly.  However, let's ignore that.  If you use real numbers, you'll see that BTID crushes the VUL policy.
 
Here's a basic comparison.  These numbers are from memory of one company's VUL and I have no idea what VUL you are using.
 
BTID expenses:
Insurance: Cheapest level term on market
Vanguard S&P 500  ER .18%
 
VUL Expenses:
5% sales charge on all premiums
S&P 500 fund ER .55%
M&E .95
 
Ignore the cost of insurance for a second and compare $10,000/year investment and look at the difference in 20 years.  Let's assume that the S&P 500 returns an average of 7% a year.
 
Results:
BTID: $429,402
VUL:  $349,000
 
Once you factor in the cost of insurance, the difference is even bigger.   Now factor in the fact that most VUL policies lapse and the VUL will be taxed as income and the index fund gets taxed at capital gains, the difference becomes immense.
 
Can you please explain why someone would pay a M&E charge inside of a VUL policy?  VUL agents think that overfunding a policy is some great thing because it lowers the amount of insurance, thus it lowers the insurance costs.  However, at the same time, it increases the cash inside of the policy which increases the M&E charge.  M&E is an insurance charge when there is no insurance.  Ex.
 
Jim has a VUL with $100,000 of cash and $1,000,000 death benefit.
Charlie has the same VUL but with $200,000 of cash and $1,000,000 death benefit.
 
Jim has more insurance charges because he is paying for $900,000 of coverage instead of $800,000.  Wrong. 
 
 Assume that the cost of insurance is $700/ per million and M&E is .95%.
 
Jim's insurance costs are ($700x .9) + (.095 x $100,000) = $1,580
Charlies insurance costs are ($700 x .8) + .95 x $200,000)= $2460  (He's throwing away an extra $1900 in M&E costs  for absolutely nothing in return.  He's also paying extra for his insurance.  He's also paying an upfront sales charge with no breakpoints on the investment portion.  He's paying an upfront sales charge for his insurance.  He's being charged extra for the funds.)
 
 
 
May 30, 2009 9:23 pm
today1:

if the client has a 10-20 year time frame an overfunded vul works great.  if you run the calculations and factor in taxes it makes sense.   another reason is that taxes are at an all time low right now with only one way to go...up.  if you think its a great idea to keep funding other tax deferred vehicles, like annuites, that you will only have to pay taxes on later you are missing the boat.  it is better to diversify your tax liabilities.  and in reality if you factor in the cost of other programs like variable annuities the costs arent that much different.  do the research and i think you might agree on these types solutions.

 
 
Today, for years, I've been trying to get someone to use a real life example of VUL being the best option for someone.  Are you up for the challenge?
May 30, 2009 9:26 pm

i'd like to know what probability model you are all using that says taxes have nowhere to go but up.

 
that is a sales tool used to sell those LIRPs.  i remember, "Mr Client, do you think taxes are going to be higher or lower when you retire?". 
 
also, what is going to be your level of overfunding?  the guy makes 75k a year - not much.  what are his expenses?  does he travel a lot?  what level are you going to set the LIRP?  $20k a year?  he's only getting $20k, correct?  there are minimums I believe as well.  and don't you have to fund it for ten years (I actually don't know, so I could be wrong).  regardless, I don't think this guy is a candidate. 
 
buy some cheap, good quality stocks, and have him hold them until he retires.  he doesn't pay any taxes because he doesn't sell them.  he'll be in a lower tax bracket when he retires and can take dividends or a portion of the profits.  either way, the money is tax deferred.
 
as for whether his "enhancement" is tax-free - his attorney should know the answer to that, which should be information he provides to you.
May 31, 2009 11:11 am
anonymous:

"What's wrong with an overfunded VUL? You can put it in index funds to keep costs low in the subaccounts, all money that goes in can now grow tax deferred and if USED properly, can be used as an awesome tax free income stream"



 
Compare this to buying term insurance and investing the difference (BTID).  I happen to think that BTID is a nonsensical topic, but it is exactly what VUL does.  VUL combines overpriced term insurance with overpriced investments.
 
Your line "if USED properly" is huge.   Real life gets in the way causing these products to never be used properly.  However, let's ignore that.  If you use real numbers, you'll see that BTID crushes the VUL policy.
 
Here's a basic comparison.  These numbers are from memory of one company's VUL and I have no idea what VUL you are using.
 
BTID expenses:
Insurance: Cheapest level term on market
Vanguard S&P 500  ER .18%
 
VUL Expenses:
5% sales charge on all premiums
S&P 500 fund ER .55%
M&E .95
 
Ignore the cost of insurance for a second and compare $10,000/year investment and look at the difference in 20 years.  Let's assume that the S&P 500 returns an average of 7% a year.
 
Results:
BTID: $429,402
VUL:  $349,000
 
Once you factor in the cost of insurance, the difference is even bigger.   Now factor in the fact that most VUL policies lapse and the VUL will be taxed as income and the index fund gets taxed at capital gains, the difference becomes immense.
 
Can you please explain why someone would pay a M&E charge inside of a VUL policy?  VUL agents think that overfunding a policy is some great thing because it lowers the amount of insurance, thus it lowers the insurance costs.  However, at the same time, it increases the cash inside of the policy which increases the M&E charge.  M&E is an insurance charge when there is no insurance.  Ex.
 
Jim has a VUL with $100,000 of cash and $1,000,000 death benefit.
Charlie has the same VUL but with $200,000 of cash and $1,000,000 death benefit.
 
Jim has more insurance charges because he is paying for $900,000 of coverage instead of $800,000.  Wrong. 
 
 Assume that the cost of insurance is $700/ per million and M&E is .95%.
 
Jim's insurance costs are ($700x .9) + (.095 x $100,000) = $1,580
Charlies insurance costs are ($700 x .8) + .95 x $200,000)= $2460  (He's throwing away an extra $1900 in M&E costs  for absolutely nothing in return.  He's also paying extra for his insurance.  He's also paying an upfront sales charge with no breakpoints on the investment portion.  He's paying an upfront sales charge for his insurance.  He's being charged extra for the funds.)
 
 
 
 
Anon - I don't think you drink enough alcohol.
May 31, 2009 3:51 pm

Bobby, on that comment, I must agree.  I definitely should be drinking more.