“What if traditional retirement savings plans are actually getting in the way of your retirement freedom?” Bold questions like these are what set you apart from compliance-only tax professionals. As a proactive tax planner, you know that no two clients’ situations are identical. So why would you recommend the same tax strategies to everyone? This is especially true when it comes to a topic like retirement planning where so many different strategies exist, and some of the lesser known pathways can be extremely tax-advantaged.
In today’s blog, we will challenge a decades-old assumption that the path to retirement must be paved with 401(k)s and IRAs. Of course, some taxpayers will find these to be the most accessible and beneficial solutions. However, others might find themselves burdened by the mandatory contribution rules, mandatory distributions, age limits, withdrawal penalties, and other restrictions that come with these plans. Not only that, retirement plans can lead to a higher tax bill if the taxpayer ends up in a higher tax bracket after retiring. These taxpayers may want to opt into an alternative retirement strategy like the one we’ll discuss today: using captive insurance.
Benefits of Captive Insurance
To set up captive insurance, the main business must establish a property and casualty insurance company that is owned by the company it insures. Just as they would with a third party, the business pays premiums to gain insurance coverage. Of course, this setup is already a benefit: your client is simply moving money from their original business to the new insurance entity that they also own.
Another major benefit is that the captive insurance company may not have to pay taxes on its premium income. To secure this benefit, your client must take two important steps: 1) their business must make an 831(b) election, and 2) they must keep their annual premium payments under a certain threshold, which is set at $2.85 million for 2025. As long as the premiums do not exceed that threshold, that income is tax-exempt.
However, the insurance company does have to pay tax on any investment income. By law, all captive insurance companies are taxed as C corporations regardless of how they are structured. Keep in mind, this means the taxpayer will face the usual double taxation: the 21% corporate tax rate paid by the business and capital gains tax when the income is distributed to the business owners. The capital gains rate could be 0%, 15%, or 20%, depending on the taxpayer’s income level, plus a 3.8% surtax if they are required to pay net investment income tax. Even at the maximum rate of 23.8%, this may still be lower than the usual personal income tax paid on retirement plan distributions.
Taxpayers can also benefit from the flexibility offered by alternative retirement strategies. Traditional retirement plans come with required minimum distributions and allow very little control over the timing of those distributions. However, with a captive insurance company, the owner can take distributions whenever they predict their tax rate will be lowest. This also allows them to leverage both the timing and the amount of those distributions to see if they can secure that 0% long-term capital gains tax rate.
Lastly, as a business owner, your client will appreciate that a captive insurance company does not need to match employee contributions, conduct discrimination testing, or abide by a “use it or lose it” rule.
Limitations to Captive Insurance
As tax planners well know, every tax strategy comes with its benefits and its drawbacks. Captive insurance does face certain restrictions that you need to keep in mind before recommending this approach to a client. First, the company must maintain enough liquid assets to pay any claims. Fortunately, the money for the claims is held by your client (through the insurance entity) and paid to the client (via their main business), so again, this restriction still comes with a benefit. The exact amount that needs to be liquid is determined by the jurisdiction where the insurance company is formed. Check the rules of the state the business is formed in to make sure your client is eligible for the tax deduction.
Another requirement for captive insurance is that there must be legitimate risk. After all, that is what an insurance company exists to cover. The IRS defines “ordinary and necessary” expenses for capital expenditures like insurance in Section 263. If your client’s business does not meet the rules, their premium payments are unfortunately non-deductible.
However, the main disadvantage to note is that, unlike traditional retirement plans, captive insurance companies do not offer deferred tax-free growth. When walking your client through their options for retirement strategies, be sure to weigh all of these factors before making a recommendation.
Summary
If you are working with business owners who would benefit from escaping the restrictions that come with a 401(k) or IRA plan, captive insurance can be an attractive alternative. The upfront tax deduction on premium payments, tax exemption on premium income, and comparatively lower tax on investment income can all make the process of setting up a captive insurance company worthwhile. This is also a strategy taxpayers have likely never heard of—giving you an opportunity to demonstrate the immense value of working with a professional tax planner.
To learn about more underutilized tax strategies you can offer your clients, sign up to become a Certified Tax Planner today.
