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.
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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.