Leveraging Pre-Tax Dollars To Create An After-Tax Benefit

By John A. Oliver

Despite the effect the turbulent stock market has had on retirement plans over the last few years, many high-net-worth individuals have accumulated significant amounts in their qualified plans. However, qualified plans present a dilemma when it comes to maximizing estate preservation: They are subject to income tax and possible estate taxation at the owners death.

For individuals who do not need to access their retirement funds and wish to pass their wealth on to the next generation, this can be counterproductive to achieving their desired financial goal.

These individuals can preserve and protect their wealth through a strategy that leverages plan value and reduces tax when a qualified plan has used pre-tax dollars to purchase life insurance. This may be appropriate in cases where the qualified plan has owned a life insurance policy inside the plan for some time–circumstances may have changed, and the plan may now be interested in disposing of the policy, perhaps by sale to an irrevocable trust.

The Strategy. A qualified plan purchases a life insurance policy on the participants life (or, in the case of a profit-sharing plan, the lives of the participant and spouse). The plan utilizes its assets to purchase the contract with premiums paid by the plan for several years.

Since proceeds from a life insurance policy owned by a plan are subject to estate and, in part, income tax, the policy death benefit might need to provide for the plan participants current need for insurance protection and estate liquidity. The participants death benefit would be included in his or her estate, and beneficiaries would receive the portion of the death benefit equal to the policy cash value as an income taxable distribution. The portion of the death benefit in excess of the policy cash value would be income tax free.

To illustrate this strategy, lets look at an example of a couple with a qualified profit-sharing plan (PSP). Bill and Penny Moneysworth are 72 and 64 years old, respectively, and have an estate worth approximately $15 million. They are still active owners-employees in their closely held business. They set up a profit-sharing plan (PSP) for themselves decades ago. The plan now has account values in excess of $2 million.

Bill and Penny have other sources of income and do not need to access the PSP now or in the future, although they will have to take minimum distributions.

Based on the size of their estate, the Moneysworths have a need for approximately $5 million of life insurance. Currently, the PSP owns a survivorship life insurance policy on the lives of Bill and Penny that was purchased a few years earlier. Scheduled premiums have been, and will continue to be paid by the plan for several years.

The policy has a current death benefit of $10 million. Since the proceeds would be subject to estate taxes and some income tax if the Moneysworths were to die while the plan owned the insurance policy, the high death benefit is sufficient to meet their ultimate need for $5 million. With this type of scenario, now may be the right time to implement this strategy.

Removing the Policy from the Plan. After a number of years, it may become desirable to remove the policy from the plan. To keep the policy in force and the proceeds out of the Moneysworths gross estate, the Moneysworths establish an irrevocable trust to acquire the policy from the PSP.

There are a number of options that can be implemented to successfully transfer the policy from the PSP to an irrevocable trust. One option is to gift the funds to the trust so that it can eventually purchase the policy from the plan. This action, however, may trigger gift taxes if the client does not have ample annual gift tax exclusions.

Another option is to use premium financing, where a third-party lender makes it possible for the trust to borrow funds for the purchase of the policy directly from the plan (see Figure). The client would then gift an amount equal to the annual interest due on the loan to the trust and determine, based on the situation, if the loan will be repaid before or upon death. Of course, these gifts could also cause the payment of gift tax depending upon the clients situation.

Reducing the Face Value. Continuing with our example, once the policy has been sold to the Moneysworths trust, the death proceeds have been successfully removed from the gross estate. Thus, it may be desirable to reduce the policy face amount.

Many insurance companies allow a one-time face amount reduction during the policys surrender charge period without any cost to the policy owner. Since Bill and Penny no longer have the need for $10 million in life insurance, the trustee reduces the face amount of their policy to their current insurance need of $5 million.

Furthermore, with a new lower face amount, there may be sufficient cash value accumulated within the policy to make an adjustment to the policys required annual premium.

Choosing the Appropriate Policy Type. Some insurance professionals are using policies for this strategy that are extremely low in cash value in the early years compared to total premiums paid. As with all types of policies, when the time comes to sell the policy to the irrevocable trust, the issue of proper valuation arises.

Under the Department of Labors Prohibited Transaction Exemption (PTE) 92-6, a plan is permitted to sell an individual life insurance contract for at least its cash value. But some tax commentators believe that, depending on the individual situation, the policys cash value may not be an accurate representation of its fair market value.

It is currently unclear how the IRS will ultimately value a policy in this type of transaction. Therefore, it may be wise to use policies that have the same values and features when issued either inside or outside a qualified plan, and avoid policies specifically designed only for issue inside a qualified plan with extremely low cash values as compared to premiums paid.

Finding new ways to help clients preserve their estates is the name of the game for insurance and financial professionals. Through careful planning, this strategy is one way clients with substantial qualified plan assets can leverage their pre-tax dollars to realize after-tax estate benefits.

John A. Oliver is vice president, strategic marketing services for Transamerica Insurance & Investment Group, Los Angeles, Calif. He can be reached at john.oliver@transamerica.com.


Reproduced from National Underwriter Edition, May 5, 2003. Copyright 2003 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.