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A Smart Approach to Retirement for Small-Business Owners

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Uncertainty in the tax code and the looming possibility of an increased tax burden continue to perplex small businesses. Among the chief concerns are a number of soon-to-expire tax provisions that may result in rising income, capital gains and estate taxes in 2013.

As a result of this uncertainty, many small-business owners who have experienced consistent profits are now — more than ever — interested in exploring tax-saving strategies. According to a survey by the National Federation of Independent Business, 22% of small-business owners say that taxes are the single most important external impediment to growth. Informed advisors who have mastered strategies that address this concern can seize this life insurance sales opportunity.

A strategy that makes sense

Small-business owners who are interested in maximizing retirement savings and minimizing income tax liability may consider implementing a qualified plan, such as a cash balance or traditional defined benefit plan. These plans are eligible for favorable tax treatment under the Internal Revenue Code (IRC), provided certain requirements are met. This favorable tax treatment includes tax-deductible contributions for employers and self-employed individuals, tax-deferred growth, and the ability to roll over plan benefits into an IRA or annuity after separation from service.

Generally, defined benefit plans can be funded with various assets. Life insurance is a particularly advantageous asset to own within a defined benefit plan for the following reasons:

  • It can maximize contributions and their attendant income tax deductions. Employer contributions to a defined benefit plan are determined according to an actuarial calculation, which takes into account an assumed growth rate. As such, plans that are funded with assets that have a conservative growth rate — such as life insurance — require larger contributions. Larger contributions translate into larger income tax deductions.
  • It can help with retirement planning. The success of a retirement plan hinges on a time horizon that is long enough to support regular contributions and earnings growth. In the event that this time horizon is unexpectedly cut short, the entire plan is impacted. However, a life insurance policy can provide an immediate lump sum to replace earnings that would have accumulated had the plan participant survived and continued making contributions. This benefit is particularly valuable when a non-working spouse is depending on the retirement account of a working spouse.
  • It can be funded with pre-tax dollars. Plan participants can purchase the life insurance they need on a pre-tax basis. However, it’s important to note that participants will include in income the yearly economic benefit cost of life insurance protection provided by the plan.

See also: Paying Life Insurance Premiums with Company Cash Flow: The Tax Effect

  • It’s portable. The life insurance policy is portable because it can be rolled to another qualified plan, distributed from the plan or purchased from the plan by the participant. This allows participants to maintain their life insurance policy, even if they are separated from service and no longer part of the initial plan.
  • It’s tax-efficient. Unlike other assets owned inside a qualified plan, a portion of the death benefit can be passed along to beneficiaries free from federal income taxes.


Where you come in

Small-business owners who recognize the value of life insurance in qualified plans must also negotiate certain tax pitfalls, namely the federal estate tax. The death benefit of a life insurance policy owned by a qualified plan will be included in a participant’s taxable estate. The large unified credit exemption available in 2012 of $5.12 million per person ($10.24 million per married couple) may shelter estates from estate tax for participants dying before December 31, 2012. But beginning January 1, 2013, based on current tax law, participants will only have a $1 million unified credit exemption ($2 million per married couple). Small-business owners need to consider not only the death benefit being included in their estate, but also the date-of-death fair market value of their business interest — which can create a sizable gross estate. Thus, participants (who are also business owners) in plans that contain a life insurance component should be especially keen on the exit strategies available when trying to remove a life insurance policy from a qualified plan for purposes of eventually removing the death benefit from the participant’s gross estate.

Informed advisors can offer various solutions to this problem:

  • Distribute the policy from the plan. The plan may be able to distribute the policy to the participant, who may thereafter gift the policy to an irrevocable life insurance trust (ILIT) or a loved one in order to get the life insurance death benefit outside of his or her taxable estate. The participant will be responsible for paying income tax on the plan distribution based on the fair market value of the policy and any gift tax that may be due.1
  • The ILIT can purchase the policy from the plan. The participant’s ILIT could purchase the policy from the plan, thereby avoiding application of IRC §2035 (a.k.a., the three-year look-back rule for estate inclusion).2 It should be noted that, by paying fair market value for the policy, the participant is using funds he or she might want to use for another purpose.
  • The policy can be rolled over. Lastly, the policy could also be rolled over into another qualified plan, as long as the plan document allows for it. However, note that life insurance cannot be rolled over to an IRA.
  • Other solutions are available. Other flexible solutions are available from some carriers that provide individuals with the tax benefits of both a qualified retirement plan and a life insurance policy (paid for with pre-tax dollars), while also offering the possibility of obtaining new coverage outside the plan. With this feature, the plan can surrender the life policy beginning in the eighth policy year and roll the cash surrender value — along with other plan assets — into an IRA, producing a tax-neutral consequence. Thereafter, the insured participant can obtain coverage on a new life insurance policy outside the plan for the net amount at risk without being subjected to new underwriting. For example, Doug, a business owner, is age 65 and a qualified plan participant. He has a $1 million whole life policy with a $400,000 cash surrender value in his plan. The plan trustee surrenders the policy, and Doug rolls the $400,000 into an IRA on a tax-free basis. Then, a new $600,000 policy is issued outside the plan — perhaps with the insured’s defective ILIT as the policy owner in order to shelter the death benefit from estate tax — without subjecting Doug to additional underwriting.

The takeaway

Finding innovative solutions to protect business owners’ current profitability, retirement planning needs and estate planning concerns is important in today’s uncertain tax environment. Being able to identify the value of strategies involving life insurance in qualified plans can provide valued savings to a business owner and help preserve the business owner’s estate for loved ones.


  1. The IRS has provided some guidance on calculating fair market value with Revenue Procedure 2005-25.
  2. Note that the ILIT would have to be defective as to the grantor in order to avoid application of IRC Sec. 101(a)(2), which could subject the death benefit to income tax.

For more on estate planning, see:

Advisors, Use This Wealth Transfer Strategy While You Can

4 Ways to Deal With Estate Tax Uncertainty

Boomers Aren’t Interested in Leaving Money to Heirs


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