A qualified plan is a terrific asset accumulation tool and adopting one is a good idea for successful business owners who want to save on current taxes and grow money for their retirement. Many business owners find that after establishing a qualified plan they are so enamored with watching their money grow without paying current income taxes that their qualified money is the last money they want to use when they finally get to retirement.

But this is where too much of a good thing can suddenly turn into terrible news. Qualified assets–either in a qualified plan or an IRA–can be reduced by as much as 80% by income and estate taxes at death. And that is very bad news.

Sad ending, happy ending

Consider Pat and Chris, a husband and wife team with a successful consulting business. They have personal assets with a net value of more than $3 million and establish a conventional defined benefit plan to save on current income taxes. In 10 years they will be happy to have accumulated another $2.1 million in the defined benefit plan, increasing their net worth to more than $5 million. When they stop working, they roll the qualified plan money into IRAs, where the funds continue to grow.

Pat and Chris like the tax-deferred growth in their IRAs and don’t want to pay more current income taxes than they need to, so they draw on other assets for income. They plan to leave the IRA assets to grow until they are forced to take required minimum distributions and plan to pass on whatever remains at death to their children.

Here’s the sad part of the story: The $2 million IRA they were planning to pass on to their children could end up being $800,000 or less.

There can be a happier ending with some smart planning. Life insurance is an ideal tool to replace potentially heavily taxed funds with a tax-free death benefit. Paying for the life insurance with pre-tax dollars can be even better.

If we add life insurance to Pat and Chris’ defined benefit plan, we can provide an immediate death benefit. Should Pat or Chris die, the pure death benefit (or face amount) will pass income tax-free to their beneficiaries. The full premium for the insurance is tax-deductible as part of the qualified plan contribution. (See chart 1.)

Adding $3.4 million of life insurance coverage to their plan increases their deductible plan contribution by only $55,771, though the total premiums for the life insurance are $97,219. Taking into account that the $55,771 is tax-deductible as a plan contribution, at a 34% tax rate the net after-tax cost for adding the insurance is only $36,809. (See chart 2.)

To purchase the same coverage outside the plan, Pat and Chris would have needed earnings of $147,301 to net enough to pay the $97,219 premium after taxes (assuming a 34% tax rate).

When using a qualified plan to purchase life insurance it is important to look beyond the current benefits of the tax deduction and think about an exit strategy. Failure to plan can cause your client to be subject to unwanted income and estate taxes. Often, you will not want to leave the life insurance in the plan until retirement.

There are 3 ways to move life insurance out of a qualified plan. First, the policy can be distributed to the participant upon the occurrence of some triggering event, such as retirement or termination of service. When a policy is distributed, the participant who receives it must pay income tax on the fair market value of the policy, less any accumulated taxable term costs (formerly known as the P.s. 58 costs) paid.

This could be a substantial amount if the policy has been in the plan for an extended time. And because life insurance cannot be rolled into an IRA, there is no way to defer payment of the tax. The trustee could take a loan against the policy prior to distribution to reduce the value of the policy, but the recipient will then receive a policy with an outstanding loan.

Second, the plan can sell the policy to the participant. The U.S. Department of Labor has granted a class exemption (PTCE 92-6), which allows the policy to be sold to the participant if certain requirements are met. The policy must be sold for an amount equal to its value had the qualified plan trust retained or surrendered the policy.

Being able to sell the policy out of the plan creates flexible planning opportunities. For example, a policy can be purchased in the qualified plan and premiums paid on a tax-deductible basis for the early years of the policy. Then before cash values grow unmanageably large, the plan can sell the policy to the participant, moving the policy into an irrevocable trust to remove it from the estate. The technique enables the insured to “prime” the policy with tax-deductible dollars and provides a cost-effective way to purchase life insurance for estate planning purposes.

A third option offered by some insurance companies is to exchange the policy. In this scenario, the policy is surrendered within the qualified plan so that the cash value of the policy after any applicable surrender charges can be added to other plan assets and rolled into an IRA to continue tax-deferral. In its place a new policy is issued outside the plan for the same insured, often without any medical underwriting. That policy can be placed in an irrevocable trust and be used for estate planning purposes.

Eye on the future

For clients without an estate large enough to be subject to estate taxes, buying life insurance inside a qualified plan may be advantageous. But for a couple like Pat and Chris, without further planning the life insurance will compound their estate problem because life insurance in a qualified plan is not excluded from the estate.

By purchasing life insurance in their qualified plan with an eye to their future goals, Pat and Chris can gain the dual advantage of leveraging the benefits of current tax deductions and planning to protect their estate at death. With careful planning they can have the peace of mind that comes with knowing no matter what the future brings, their children will benefit from their success.

Mary Read, CPC, QPA, is vice president of qualified plan marketing at National Life Group, Montpelier, VT. You may e-mail her .