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.
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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.
- 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.