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Miguel Palma
Miguel Palma
Ignoring Tax Class Diversification

Are you setting up future tax bombs for your clients?

November 17, 2011
by Miguel Palma, CPA, PFS

Warren Buffett is widely regarded as one of the most successful investors in the world. Here are a few Quotes from the “Oracle of Omaha” on diversification:

  • “Diversification is a protection against ignorance.”
  • “Risk can be greatly reduced by concentrating on only a few holdings.”

Based on these quotes, it is obvious Buffett is not a big fan of diversification. But most of us and our clients are not Warren Buffett.

Every time we turn on the financial channels or attend an investment seminar someone is promoting diversification. This notion has been part of mainstream financial planning for a long time. There is a widespread belief in the truth of statements such as “studies show that asset mix determines 93.6 percent of the return of a portfolio.” This concept has become a financial mantra and has become second nature. For now let’s just assume diversification is critical for the long term health of a portfolio.

As CPAs and Personal Financial Specialists (PFSs), are we truly serving our clients best interest by only emphasizing the funding of retirement plans for today’s “tax write-off”, instead of considering the concept of tax class diversification during the tax and financial process with our clients?

Are we telling our clients the whole story? Are we really helping them prepare for their financial future? Over the last 13 years, I have personally designed and established over 80 qualified pension plans, mostly defined benefit (DB) plans. However, in the last five years I have been seriously considering the financial and tax logic of encouraging my clients to only focus their resources on tax deductions by funding qualified plans exclusively. It is a lot easier to convince a client to fund a DB plan to generate tax write-offs, rather than having the client pay income taxes now to create a tax-free income stream in the future and eliminating the typical restrictions of qualified plans.

One of our professional responsibilities is to educate our clients on the long-term risk of tax-deferred vehicles and the resulting tax bomb in the future. Helping our clients overcome the need for instant gratification to minimize their current income taxes is a must. Instant gratification is mainly concentrating on the immediate result and not thinking about the outcome in the future or what its effect is later in life.

Another way to look at it, instant gratification is the habit of always wanting to enjoy now and not having the patience to wait for future benefits. Anything that gives us temporary happiness or excitement, but is actually not a good thing for your life, can be put in this category.

"We care a lot more about today than about the future," explains Harvard economics professor David Laibson. "Humans, like a lot of other animals, place full weight on what happens right now and half weight on what happens even a few days away."

That's because we react emotionally to immediate gratification and think logically about future rewards. And emotion often trumps logic.

That said, why do we seem to neglect the idea of diversifying from a tax-class perspective? If we diversify our asset classes so that losses do not negatively impact our financial pictures as much, then doesn’t it make sense to use the same logic for tax classes?

In November 2011, the national debt is $14.9 trillion, it is more than likely income tax rates will increase in the coming years and we may experience significant changes in the U.S. tax code, as increasing tax revenues will be a way that our government tries to lower this debt. Therefore, tax class diversification is a must.

When I first introduce this concept to my clients I simply refer to tax classes as “future income buckets”; a taxable income bucket and a tax free income bucket. I often asked my clients “when you access your money in the future, which bucket would you rather access the tax-free bucket or the taxable bucket?” Obviously, most of my clients always answer the tax free bucket.

When we access our money, there are only two categories from which we can pull money. The first one is the taxable category, which includes tax deferred, tax qualified plans and various types of annuities to name just a few. There will be taxes due as we take distributions out of this category. The second category is tax-free income, when qualified distributions are taken. The Roth IRA is a well-known financial vehicle in this bucket.

There is a lesser-known financial vehicle for generating tax-free income in the future. The latest tool in my arsenal for creating tax free income is the Section 79 Permanent Benefit Plans. The Section 79 plan is a benefit plan designed to provide permanent benefits that are in addition to the group term-life insurance available through IRC Section 79. Under such arrangements, employers can offer group term life insurance to their employees up to $50,000 of death-benefit coverage income tax-free. In addition to the term insurance, employers may also provide permanent benefits in the form of cash value life insurance policies, the premium, which is fully deductible to the corporation and a percentage of the premium payments must be included as taxable income by the participants. Since the owners of C corporations qualify as employees under the plan, they are eligible to take advantage of the attractive features that are available to the participants of a Section 79 plan. As business/owner participants, business owners can fully deduct the contribution/premium payments through the C Corporation, while recognizing only a portion of the premium. The participant has the ability to access the policy cash-values income tax free for supplemental retirement income or other purposes.

This program has become very popular with my clients since it requires minimal compliance work or third-party administration and provides significant leveraging between the full deduction to the corporation and the percentage recognized by the owner/participant as income. The income stream is tax free and the plan is not subject to the restrictive requirements of qualified plans. Furthermore, the cost to cover non-highly compensated employees is approximately $125 per year, however if the employee is willing to recognize additional benefits and can afford the additional income taxes the cost to the employer maybe higher. As a CPA/PFS, it would be great if you were able to provide your clients, in retirement, the flexibility to choose which bucket to access for income based on the current tax rates. This strategy will help your clients minimize the negative effect income taxes will have on their nest egg and maximize their annual income stream.

Remember that diversification is only part of the story. In order to truly prepare and maximize your clients’ future income stream, current and possible future income taxes must be taken into consideration. Be sure to talk to your clients about the full diversification process to provide them with the flexibility to choose between the different income “buckets” and meet your professional responsibilities.

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Miguel A. Palma, CPA, PFS is located in Dublin, CA and is an independent investment adviser. CA License OD26263. The AICPA’s PFP Section provides information, tools, advocacy and guidance to CPAs who specialize in providing tax, retirement, estate, risk management and investment advice to individuals and their closely held entities. All members of the AICPA are eligible to join the PFP section. For CPAs who want to demonstrate their expertise in this subject matter, apply to become a PFS Credential holder.

To ensure compliance with requirements imposed by the IRS, we inform you that any U.S. federal tax advice contained in or accompanying this document, unless otherwise specifically stated, is not intended or written to be used and cannot be used, for the purpose of (i) avoiding penalties under the Internal Revenue Code or (ii) promoting, marketing or recommending to another party any transaction or matter that is contained in or accompanying this document. This article was written to support the promotion or marketing of the tax matter, opportunity or transaction described therein and we urge individual recipients of the document to seek tax advice based on their particular circumstances from an independent tax advisor.