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Make Clients Happy With Qualified Plan Insurance Partnerships

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Make Clients Happy With Qualified Plan Insurance Partnerships

When an individuals estate is faced with using a qualified retirement plan or IRA withdrawal to pay estate taxes, 70% or more of those otherwise tax-deferred funds can be lost almost immediately to taxation.

Similarly, when an individual desires to leave a retirement account to one beneficiary and the nonretirement account assets to another beneficiary, the question often arises of how to pay estate taxes attributable to the retirement account without: (1) making a withdrawal from the account, or (2) burdening the beneficiaries of the nonretirement account assets with the tax liability attributable to the retirement account.

Life insurance can be a perfect solution to these dilemmas. The following “success stories” demonstrate the use of an estate planning strategy known as a “Qualified Plan Insurance Partnership(R)”? (QPIP?), which can allow retirement accounts (including IRAs) to contribute to life insurance premiums without triggering a current income tax, thereby providing a source of tax-free dollars for the payment of estate taxes or any other purpose for which the retirement account participant desires such liquidity.

Case Study #1: Bill and Monica, aged 70 and 69, respectively, are married. The intended beneficiaries of their estates are their children and grandchildren. While Bill and Monica have a significant combined taxable estate, approximately $18 million, their wealth is comprised largely of their retirement accounts: $6 million IRA for Bill and $1.2 million IRA for Monica; and their remaining interest in the family business, a large portion of which they have transferred to their children as part of a lifetime gift program.

Bill and Monicas accountant recommended their grandchildren be designated as the beneficiaries of their IRAs in order to “stretch out” the tax deferral of those accounts for as long as possible after their deaths. A $13 million second-to-die life insurance policy was also recommended to assist in the payment of estate taxes and to replace, for the children, amounts passing to the grandchildren.

Facing an annual premium outlay of $275,000, Bill and Monica needed to identify a source of funds that could be used to cover this expense. Given their limited liquidity, they were uncertain how the premiums would be funded. Bill and Monica were not interested in taking taxable withdrawals from their IRAs beyond the Required Minimum Distributions, which are used for their living expenses. Their insurance advisor suggested the use of the QPIP strategy as the solution, and after careful consideration of the strategy, Bill and Monica decided to use the QPIP (see sidebar for an overview).

Upon establishment of the LLC, Bills IRA contributed $2.7 million in exchange for an 81.82% ownership interest, while an irrevocable trust established by Bill and Monica received a gift of $550,000 from them and then contributed those funds to the LLC in exchange for a 16.67% ownership interest. Finally, Bill and Monica contributed $50,000 in exchange for a 1.51% interest (which they contemplate transferring to the irrevocable trust in the future). Thus, the LLC was capitalized with $3.3 million.

The LLC is expected to generate an annual return of 8%. Based upon this level of capitalization, the LLC should generate sufficient earnings annually to fund the life insurance premiums. Under these assumptions, if the survivor of Bill and Monica dies in year 18 (their life expectancy, based upon IRS tables), then Bills IRA would receive $7,706,716 in return for its $2.7 million investment, while the irrevocable trust would receive $8,578,769. This represents a rate of return of 15.9% for the irrevocable trust and a 6% rate of return for the retirement account.

Moreover, the return to the irrevocable trust would be even greater if the survivor of Bill and Monica dies prior to their actuarial life expectancy.

For example, if the survivor dies in year 6, then the rate of return to the trust would be 65.7%–free of both estate and income taxes.

Case Study #2: Consider the case of Jane, a retired executive of age 60. Janes estate consists of $5 million in her IRA, cash and investments totaling $250,000, and her residence currently valued at $450,000. Jane is also receiving payments pursuant to a deferred compensation plan from her former company for the next 10 years–adequate to cover her living expenses.

Jane would like to leave a net after-tax amount of $1 million to each of her three children, but also is committed to providing significant amounts to a charity upon her death. Janes estate planning attorney explains that this may not be possible in light of the estate and income taxes that could be imposed upon the IRA at the time of her death.

Janes life insurance advisor recommended a $3 million life insurance policy to be owned outside of Janes taxable estate. This policy would allow Jane to provide for her children as stated above, and also permit her to leave her IRA to charitable organizations and thus avoid both income and estate taxes on the IRA.

The scheduled annual premium for the recommended policy is $76,411 for a 10-year period. One of Janes options for funding the premiums was to make taxable withdrawals from her IRA, followed by an after-tax annual contribution to an irrevocable life insurance trust that would own the policy.

This approach would have required, assuming a combined federal and state income tax of 45%, total withdrawals from the IRA of $1.4 million over 10 years. Jane was concerned that such withdrawals could significantly diminish the IRA and thus frustrate her charitable intentions.

Janes estate planning attorney suggested that she consider the QPIP strategy to assist in the payment of premiums. After consideration of the strategy, its potential benefits and risks, Jane decided to establish a QPIP.

Upon establishment of an LLC, Janes IRA contributed $940,000 in exchange for a 94% ownership interest, while an irrevocable trust that Jane established received a cash gift of $50,000 from her, and then contributed those funds to the LLC in exchange for a 5% ownership interest. Finally, Jane contributed $10,000 in exchange for a 1% interest, which she expects to transfer to the irrevocable trust in the future. Thus, the LLC was capitalized with $1 million.

The LLCs investments are expected to generate an annual return of 8%. Based upon this level of capitalization, the LLC should generate sufficient earnings annually to fund the life insurance premiums, while still allowing the investment portfolio to remain intact.

Each time the LLC pays an insurance premium, an amount equal to the cost of the death benefit protection offered by the contract is charged against the capital account of the irrevocable trust. The balance of the premium is charged against the IRAs capital account.

Once the period for paying premiums has expired, the IRA trustee might elect to withdraw from the LLC. The LLC operating agreement would limit the amount to which a member is entitled if the member withdraws from the LLC prior to the date set for its termination.

For example, the amount payable upon withdrawal could be tied to the fair market value of the LLC units at the time of withdrawal. In Jane’s case, if the IRA withdraws in year 10, then it will be entitled to receive approximately $1,657,130 from the LLC. This is the value of the IRAs LLC interest, less a 20% discount.

While the LLC will have assets other than the life insurance policy, it may not have assets sufficient to satisfy its obligation to the IRA if the IRA chooses to withdraw. Assuming the LLC has $1 million available to repay the IRA, then the LLC could issue a note payable to the IRA equal to the balance of the amount to which the IRA is entitled upon withdrawal. The interest on the note could be payable annually or accrue until maturity (defined as Janes death or dissolution of the LLC).

For example, assume the note accrues interest at 6% for 5 years until Janes death at age 75. In that event, the IRA would be entitled to receive $909,525 at Janes death, to be paid from the life insurance proceeds. The balance of the insurance proceeds–$2,090,475–would be paid to the irrevocable trust free of income and estate taxes.

After the IRA withdraws, the sole member of the LLC would be the irrevocable trust. At Janes death, the LLC would use the death proceeds it collects to pay off any debt it may then owe to the IRA. The remaining death benefit will be allocated to the capital account of the irrevocable trust, the sole member. This amount could be withdrawn by the trust–free of both income and estate taxes–and distributed to Janes children in the manner specified in the trust agreement.

In addition, Janes IRA would be distributed tax-free to the charities listed on her beneficiary designation, and her residence and personally owned investments would pass tax-free to her children, having been sheltered by her estate tax exemption amount.

Conclusion: In sum, use of the QPIP strategy yields the following potential benefits:

?–It has allowed much of the expense associated with acquisition and maintenance of the insurance policy to be paid with pre-tax dollars and the earnings generated by the LLC. This is especially beneficial as the term costs increase each year as a result of the insured persons age.

–?It has limited the amount of death proceeds includable in the insureds estate, while making IRA funds available for the overall benefit of the family on a tax-free basis.

–It has allowed the use of IRA assets to contribute toward insurance premiums, since an IRA is not prohibited from owning limited liability company interests so long as the LLC does not constitute a disqualified person.

While careful analysis supports the conclusion that the investment of retirement account assets in a properly structured QPIP does not violate either ERISA or the Internal Revenue Code provisions dealing with qualified retirement plans, there are several issues involved for which there is no direct authority. Neither the Department of Labor nor the Internal Revenue Service has issued a ruling that addresses the QPIP technique.

Andrew J. Willms is the founding shareholder and Jason R. Handal, pictured above, is a shareholder in the law firm of of Willms Anderson, S.C., Theinsville, Wis. They may be reached via e-mail at [email protected] and

[email protected].

“QPIP” and “Qualified Plan Insurance Partnership” are registered trademarks of Estate Counselors, LLC.

Reproduced from National Underwriter Life & Health/Financial Services Edition, September 10, 2001. Copyright 2001 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.

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