In our latest interview with Peter Hibbard, we will be discussing how highly compensated individuals able to shelter their income while preventing taxes by using a captive insurance company.
Transcript Edited For Clarity
“With recent tax proposals, how are highly compensated individuals able to shelter their income while preventing taxes?”
Enpo: Good afternoon. Is this Peter?
Peter: Hello this is Pete.
Enpo: Good afternoon Pete. This is Enpo calling on behalf of My Financial Coach for our My Financial Coach – Live! webcast. How are you doing this afternoon?
Peter: I’m doing very well. How are you?
Enpo: Excellent. So on our program, we like to reach out to some of our Subject Matter Experts who have proficiency in a lot of different areas. And so for the benefit of our listeners at home, could you give a little bit of background about yourself and your firm?
Peter: Yeah I started in this business in 1971, so you might say that I’ve been in the business for 50 years if you do the math. I started in the life insurance business at first, and then.. I’ve always been in the life insurance business, but then in 1974, I started my pension consulting company called CBC Retirement Partners where we design and implement all forms of retirement plans for businesses of various sizes. But, we have really been emphasizing in recent years very high, very large tax deductions for business owners who have the capacity to need deductions for themselves and key employees. 500 to a million dollar range each. But, we also get involved with some other areas. One of the big things these days is, we hear all the stuff going on at the congressional level and our new administration is, they want to increase taxes for those earning over $400,000 a year. So, if that is true, and it actually comes to fruition, I have many clients that are putting money into deferred compensation and qualified plans that are going to be paying a higher tax and are going to take it out as opposed to putting money in.
Enpo: Well, Pete. I’m glad that you were able to give some background about yourself and your firm. It actually brings us to today’s topic for our conversation. With recent tax proposals anticipated to increase taxes on high income earners, both now and in the future, how are highly compensated individuals able to shelter their income in a meaningful way while preventing taxes potentially today and in the future.
Peter: There is a number of ways that we have developed, a number of tax strategies. You know, if I look for example in one area in the qualified plan arena, most advisors … you know, they go in and they say “Hey, you need a 401k or you need a defined benefit plan” but they will implement perhaps a cash balance plan. Which, for the age 52 year old, maxes out with contributions of about $270,000. Most financial advisors don’t know that with another design, with documents approved by the Internal Revenue Service, you can actually take that tax deduction upwards of $500,000 a year. But most financial advisors don’t know… I’ve been in the business so long, I know sections of the code, and our actuaries know sections of the code… they have been on the books for 20-30 years. Most financial advisors don’t know that those code sections are still available. So that’s one way with a qualified plan arena. I’ve also set up a number of captive insurance companies for our clients because what happens in the qualified plan arena, if the client has a really nice tax deduction going on in the qualified plan, that will begin to drop off in terms of the amount of money that they can put in in later years, and so we have captive insurance companies that qualified to continue to increase that tax deduction as their income increases into their 50s and 60s… ages 50s and 60s.
Enpo: So, Peter, it sounds as if you have shared a lot of information with our listeners at home. It sounds as if one area, as in defined benefits, or as… many people know them colloquially as pension plans, and then the second idea is the captive insurance agency. Could you tell us a little bit more about how pension plans have been stigmatized over the years, and why people shy away from them, vs. why they actually may be a good idea, and who it may be a good idea for?
Peter: yeah, that’s the next.. sort of, question. And I’ll try not to get too deep in the weeds and confuse people, but uh… basically the stigma is primarily around if you have to include your employees. If I have X dollars to put into the retirement plan as a business owner, if I don’t money into the retirement plan, let’s say that I have to pay 40-50% tax on that, let’s make up a number, let’s say that it is $100,000 even though the deductions are larger than that. Well, if the business owner takes that as profit out of their company, they have got to pay 40% of taxes, they end up at 60%, and the stigma that many pension plans have is that if you have got to include employees, you are still going to give that kind of money away, so why… or even more if you have to pay for employees, so that is one of the bigger problems is… the money you have to fund for employees, because as you know, qualified plans can not be discriminatory and provide benefits solely for the business owner. But, there is tools and techniques that we can use in the discrimination rules to make sure that employers get 70-92%, 95% of the contribution going to the retirement plan, which makes it very tax efficient, so that is a common misunderstanding that so much money has to go to the employees. We just completed a case where the doctor was told by his CPA that “You don’t want to put it in one of those DB plans because you have got to give more that 50% of it to the employees” and we finally… the tax returns and the census and all the other information on the employer. We went back to them and said: “Hey! You don’t have to give 50% to employees, you have to give 8%. You and your spouse who works for you, you are going to get 92% of the contribution.“ That took away the stigma of having to fund employees.
Enpo: Understood. So, one of the things that people are unaware of is some of the more sophisticated strategies around… planning around captive insurance agencies. You brought that up as a second solution. What is a captive insurance agency? And, how does it work, and who is an ideal candidate for it?
Peter: The ideal candidate are the companies that have some risks around their business that they either can’t find insurance for, or the insurance that they do have… property and casualty coverage that they do have excludes certain types of coverages or benefits. And so, the basic structure is that the operating company will set up… the owner of the operating company, will set up the C Corporation, and their own insurance company designed to find insurance for the operating company. And they will hire an actuary to evaluate some of the risks you have. For example: We had one client who had material that was manufactured in China, if the ship sunk on the way from China to the United States, he couldn’t find coverage for that and he would have lost all of his product. That is just a very simple example, through the captive insurance company, we have set up that risk that if that happened to him, he could put that money into that captive insurance company, and take a tax deduction for it, and if that drastic event happened, he could reimburse himself for the losses that he had. But the biggest selling point for these captive insurance companies is primarily to cover risks that you can’t have coverage for from a traditional. Because, as you may or may not know, when you buy property casualty coverage from a property casualty insurance company, the way that they price that out is about 50% for claims and 50% profit for the insurance company. Well, you could do the same for yourself, where you are pricing the policy in your own captive insurance company that is providing coverage for you, so that you can get rid of the profit cost that goes to the traditional insurance company and keep that for yourself. But the biggest factor is, as you make these contributions to a captive insurance company from the operating company, you get a tax deduction for that. Now, the captive company does not pay taxes on it’s premium, it only pays taxes on it’s earnings on it’s reserves, and then ultimately when you shut down the captives, at some point, you will be able to take money back out of the captives and pay capital gains tax rates. So, you have converted ordinary taxes to capital gains tax rates. Plus there is estate planning that you can get involved in to pass this wealth onto the second generation.
Enpo: Alright, will Pete, it sounds as if there’s a lot you can do if you are willing to do a little bit of planning to avoid some of the taxes coming down the pike as well as do a little bit of hedging in terms of what is current and future tax rates look like. I want to thank you for sharing an overview of at least two of these strategies, and we hope that if there is anyone who is listening who wants to learn a little bit more about My Financial Coach, we are happy to bring specialists such as Pete to your attention. Was there anything else that you wanted to add?
Peter: Yes, one more thing, That is… what is totally misunderstood by the public and by financial advisors that as you create this money in IRAs and 401ks and defined benefit plans, everyone understands… and I call this unintended humor by financial advisors, they don’t know how to reposition funds and use the tax code to turn that money tax exempt or tax free. So if you have money in a 401k, DB, or IRA… rather than sitting there thinking “Oh, I have to pay income tax on that as I draw it out.” there’s methodologies there that most advisors don’t know about. In fact, our system is called a STAR system, which stands for Save Taxes and Retire. So, our STAR system turns all of that pretax money in qualified plans, it could be in IRAs and and 401ks, and DB plans, we turn that into tax exempt and tax free money. So, we an convert that to tax exempt income. So that’s one of our best strategies that we have had for years now.
Enpo: absolutely. I think that there is definitely different ways that you can solve for potential future tax increases as well as current ones that are coming down the pike. So Peter, is sounds as if the most important thing to do is to start planning and to continue to keep your eye on the plan over time.
Peter: That is correct. Which is exactly what you folks do at My Financial Coach. You do that planning process that is generally missing with a lot of clients.
Enpo: Absolutely, we do that everyday, we rely on experts like you to give us guidance on what to do afterwards. We thank you very much for hopping on the line, and have a very nice rest of your day.
Peter: You too, Enpo. Take care now.
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