For a small business owner, using qualified plan dollars to purchase life insurance protection is a strategy that can satisfy a variety of needs. It’s also a step that can make all the difference in ensuring a smooth transitioning of the business upon the owner’s exit. Using pre-tax dollars to purchase an asset that provides for a tax-free benefit can make the cost of life insurance protection much more affordable, but clients need to understand the different tax treatments that apply to life insurance when it is purchased through a qualified plan. Further, strict rules and limitations apply when life insurance is held in a qualified retirement plan, making it essential that your client has all the facts in order to ensure that a life insurance funding strategy is a success.
The Tax Benefits (and Complications)
While life insurance generally cannot be held within a retirement plan, an exception exists for life insurance policies that are held by qualified profit-sharing plans. This exception opens the door to a particularly useful strategy for small business owners because purchasing a permanent life insurance policy with qualified plan dollars can provide an attractive method for funding a buy-sell agreement that will govern in the event of a business owner’s death.
While the premiums paid on a life insurance policy outside of a qualified plan may not be tax deductible, when the policy is held within the qualified plan, premiums are paid with pre-tax dollars. This can allow the client to purchase more life insurance protection than would otherwise be affordable and can lower the cost of insurance protection for a client that is in poor health and can qualify only for a more expensive policy.
The policy premiums are paid with pre-tax dollars, but it is important that the client understands the IRS will consider the pure cost of life insurance protection provided under the plan to be an economic benefit that is taxable income to the client. The cost of insurance protection that is taxable is calculated using IRS tables and is generally provided by the insurance company that issues the policy.
Further, if the client dies while still participating in the plan (i.e., prior to retirement), the portion of the proceeds that exceeds the policy cash value will be received tax-free, but the portion of the death proceeds that represents the cash value of the policy in excess of the basis in the policy is taxable.
The Incidental Benefit Rule
Though life insurance may be purchased with qualified plan assets, strict limitations imposed by the IRS require that the life insurance protection be only “incidental” to the retirement benefits provided by the plan. (Note that IRAs and Roth IRAs are not qualified plans and, as such, cannot be used to purchase life insurance protection).
In the case of a defined contribution plan, the IRS rules provide that if a whole life product is used, the premiums paid must represent less than 50% of the contributions that the client makes to the plan. Further, if a universal life product is used, the premiums paid must be less than 25% of the contributions that the client makes to the plan.
If defined benefit plan funds are used to purchase the policy, the client may elect to satisfy a different requirement, which provides that the life insurance is considered incidental if the client’s death benefit is no more than 100 times that client’s expected monthly retirement benefit.
Removing the Policy from the Plan
One possible downside to the strategy is that the life insurance policy may be held only within the plan while the client is a participant in the plan, which can create complications depending upon the client’s circumstances at the time of retirement or plan termination.
One way to remove the policy from the plan is via a distribution of the policy to the insured when he retires (or if the plan is otherwise terminated). The downside to this option is that the client must then include the cash value of the policy that is distributed in his income in the year of distribution. Further, if the client has not yet reached age 59½, the typical 10% early distribution penalty will apply.
Another option that clients can consider is surrendering the policy and rolling the proceeds over into an IRA, but the client must be aware that, depending on the terms of the policy, withdrawal penalties may apply if this option is chosen. However, by rolling the surrender value into an IRA, no immediate income tax liability is generated.
The policy can also be sold to the client or to a grantor trust established by the client, which avoids creating current income tax liability so long as the policy is sold for fair market value. Of course, the risk of choosing this option is that the client must be able to fund the purchase at the time of retirement or plan termination.
Purchasing a life insurance policy within a qualified plan can provide a tax-advantaged method for small business clients to transition their business ownership, but a careful examination of the strict rules that apply is necessary to ensuring that the strategy will succeed for each particular client.
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