Life Insurance in the Retirement PlanLife Insurance in the Retirement Plan
This article presents an estate planner's perspective on the purchase of life insurance inside a client's qualified plan account. Buying life insurance inside a qualified plan as a way to reduce income and transfer taxes otherwise applicable to plan assets is an idea that has been presented to clients and considered by advisors increasingly often in recent years. I believe there is nothing wrong with
Natalie B. Choate, Bingham McCutchen LLP, Boston, Mass.
This article presents an estate planner's perspective on the purchase of life insurance inside a client's qualified plan account. Buying life insurance inside a qualified plan as a way to reduce income and transfer taxes otherwise applicable to plan assets is an idea that has been presented to clients and considered by advisors increasingly often in recent years.
I believe there is nothing wrong with the basic concept: In certain cases, the purchase of a low-cash-value whole-life insurance policy inside a retirement plan may be more tax-efficient than purchase of that same policy outside the plan. My purpose here is to point out details and risks that may be overlooked in rosy proposals.
THE IDEA WORKS, BUT…
Insurance is sometimes purchased inside a retirement plan as a way of depressing (temporarily, one would hope) the value of the retirement plan in order to reduce income taxes. For at least the first few years of a whole-life insurance policy's existence, its cash surrender value is, in many cases, less than the amount of the premiums paid to purchase the policy, due to the commissions and other up-front costs involved. Thus, the value of this plan asset is typically less than the value of other investments that could have been made with the same amount of money. When the policy reaches a low point of value relative to what has been invested, the policy is distributed or sold to the participant. The distribution (or sale) transaction (often called the “rollout”) is less costly than it would have been had the plan invested in something other than life insurance, or had the plan distributed cash to the participant to enable him to buy the policy outside the plan.
The expectation is that ultimately the death benefit paid under the policy to the participant's family will be worth the money spent on the policy. The essence of the tax-saving idea is that “the retirement plan pays the acquisition costs of the life insurance without necessitating a taxable distribution.”1
While this idea basically works, it is not a reason to buy insurance the participant otherwise doesn't want to buy. Remember, the reason the idea basically “works” is that the policy is a lousy investment for its first few years of existence (unless the participant “wins” by dying in those years). The worse the economic performance of the policy, the better the idea works. Carried to its most absurd extreme, a participant choosing between two equal-cost policies would choose the one with worse cash values to minimize his tax bill on rollout of the policy!
Nevertheless, the (hopefully temporary) loss of value that occurs upon purchase of a life insurance policy could be a reason to buy an insurance policy that the participant wants to buy anyway inside the plan rather than outside the plan. It is similar to buying a “load” mutual fund. Say the participant has decided to buy $1,000 worth of a particular mutual fund and must pay a 5 percent sales charge to buy that fund. It would make more sense to have his retirement plan buy the fund for $1,000 and then distribute the shares to the participant (who would then pay income tax on the net asset value of $950) than to distribute $1,000 cash to the participant (who would then have to pay tax on $1,000) and have the participant buy the fund outside the plan.
But if the participant doesn't want to buy that particular mutual fund, he shouldn't buy it inside the plan or outside the plan. If the participant is solely looking for a way to depress the value of his retirement plan, without regard to the value he gets for his money, I'd be glad to send his plan some inflated bills for legal fees to help him accomplish the goal.
There are three other concerns that arise with this particular tax-saving idea. First, proposals for buying insurance in a plan often understate the costs and overstate the benefits. Second, the tax complexities of buying insurance in a plan are sometimes minimized in describing the concept, causing unhappy surprises later. Third, it is unfortunately inevitable that some insurance sellers will go too far in tailoring policies to achieve the tax-saving goal or in trying to get the client positioned to take advantage of the tax savings.
ROSY PROPOSALS
Here are some examples of how a plan-owned insurance proposal might overstate the benefits of the idea or understate its cost.
In comparing the pre-tax cost of the insurance premiums, the agent measures the deemed income arising from the plan's purchase of the policy,2 grossed up for income taxes (purporting to represent the pre-tax cost if the plan buys the policy) against the total annual premium, grossed up for income taxes (purporting to represent the pre-tax cost if the participant buys the policy outside the plan). In this comparison, the money paid by the plan for annual premiums is ignored as a pre-tax cost of the policy.
Benefits that accrue simply from owning a life insurance policy (such as the ability to give the policy away to family members, generating a large cash estate and relatively predictable investment values) are presented in such a way as to suggest that these benefits are unique to buying life insurance through a qualified plan.
Some cost differences are not quantified, such as the increased tax cost to beneficiaries of inheriting life insurance through a retirement plan (they must pay income tax on the pre-death cash-surrender value, plus estate tax on the entire death benefit) versus outside the plan (life insurance benefits easily made income-tax- and estate-tax-free to the beneficiaries).
In analyzing any plan-owned life insurance proposal for a client, the first step is to understand the costs and benefits of the policy if purchased outside the plan, and then see how (if at all) the costs are reduced or the hoped-for benefits increased by buying the policy inside the plan.
PESKY DETAILS
Life insurance inside a qualified plan creates certain complexities that may be glossed over in the planning stage, but that later cause headaches.
Current income tax cost to the participant. The participant must pay income tax each year on the value of the current life-insurance protection provided by the plan-owned policy.3 While insurance proposals normally recognize this cost, the participant may not fully understand that he will have to pay income taxes each year on income that he does not actually receive (the “deemed” income that accrues by virtue of the existence of the policy).
Income tax issues at rollout. The tax-saving plan contemplates that the policy will be transferred out of the plan at a point of low value. In any case, the Internal Revenue Service generally requires that life insurance policies either be converted to cash or distributed to the participant no later than at “retirement.”4
The distribution would be subject to a 10 percent penalty if the participant is under age 59 — and no exception applies.5 If the life insurance policy is distributed, it cannot be rolled over to an IRA because an IRA cannot own life insurance.6 Possibly, the participant could sell the policy to the beneficiaries (avoiding the transfer-for-value rule; see below) and then roll the sale proceeds over to his IRA, thus continuing income tax deferral and avoiding the 10 percent penalty.7
Another way to capture the policy's low value, while continuing to enjoy tax deferral, is for the plan to sell the policy to the participant or to certain permitted beneficiaries.
Whether the policy is sold or distributed, income tax rules require that its value be determined. The income tax value is what is reported by the participant (if the policy is distributed to him) or used to determine whether he has paid fair market value (thus avoiding income tax, if the policy is sold to him). The low market value of the policy at rollout is a critical component of the tax-saving idea. Unfortunately, this low market value may be simply assumed in the agent's proposal. The following discussion shows that the market value of a life insurance policy, under the IRS's rules, is not necessarily easy to determine.
ROLLOUT OPTION #1
The plan distributes the policy to the participant: The participant must include in gross income the “fair market value” of the policy,8 reduced by his “basis,” or investment in the contract.9
According to the IRS, the fair market value of a life insurance policy is generally its cash surrender value.10 However, if “the total policy reserves [established by the insurer to cover the death benefit, advance premium payments, etc.] … represent a much more accurate approximation of the fair market value of the policy,” the participant is required to include the amount of the policy reserves, rather than the cash surrender value, in gross income. The reserves represent a much “more accurate approximation of the fair market value of the policy” if the policy's reserves “substantially exceed” the policy's cash surrender value.11
This is hardly a bright-line test. How much larger than the cash surrender value must the reserves be before the reserves are deemed to “substantially exceed” the cash surrender value? In the Notice's example, the reserves were 3.8 times greater than the cash surrender value and were held to “substantially exceed” it.
On the positive side, these IRS pronouncements do not seem to require that the participant's actual health be taken into account (except to the extent that it is reflected in the policy reserves). There is no suggestion that, for purposes of determining the income tax value of a policy distributed to the insured-participant, a higher value must necessarily be assigned if the participant is no longer insurable at the same rates that applied when the policy was purchased.
ROLLOUT OPTION #2
The plan sells the policy to the participant. Although this requires the participant to come up with some cash from other sources, it does allow him to continue deferring income tax on the amount represented by the policy value. The participant will own the policy (which he can transfer to an irrevocable trust, if he wants to remove the proceeds from his gross estate); and the plan will own cash, which can then be distributed to the participant and rolled over to an IRA.
Buying the policy from the plan may constitute a “prohibited transaction.”12 However, the Department of Labor has issued a “Prohibited Transaction Class Exemption” that exempts such sales if certain requirements are met.13 To comply with PTE 1992-6 when the insured participant is buying the policy from the plan, the following two requirements must be met (if the purchaser is someone other than the participant-insured, there are additional requirements; see next section):
The contract would, except for the sale, be surrendered by the plan. If the participant is retiring, this requirement is not a problem for the type of qualified retirement plan (QRP) that is required to sell or surrender the policy at that point. Also, according to one source,14 the Department of Labor considers this condition satisfied if the participant's plan account is “self-directed” as to investments and the participant directs the sale to occur, provided the participant is not subject to “undue influence” in that decision.
The price must be “at least equal to the amount necessary to put the plan in the same cash position as it would have been [sic] had it retained the contract, surrendered it, and made any distribution owing to the participant on [sic] his vested interest under the plan.” Note that this requirement does not permit any price reduction for the participant's basis.
ESTATE-TAX EXCLUSION
Once the participant acquires the policy, the participant may wish to transfer the policy to his intended beneficiaries (or to an irrevocable trust for their benefit) to get the proceeds out of his estate for estate-tax purposes. Because giving away the policy would not remove the proceeds from the participant's estate until three years after the gift,15 practitioners look for an alternative way to get the policy into the hands of the beneficiaries (or trust) without the three-year waiting period.
The plan cannot distribute benefits to anyone other than the participant during his lifetime,16 so the only ways the policy can be moved from the plan to the intended beneficiaries without triggering the three-year rule are for the plan 1) to sell the policy to the intended beneficiaries, or 2) distribute (or sell) the policy to the participant, who then sells it to the beneficiaries.
Such sales raise several issues, including where the beneficiaries will get the money to buy the policy and the “transfer for value” rule,17 under which the life insurance proceeds may be taxable income for the policy-buyers. To avoid the transfer-for-value rule, the sale may be made to a partnership in which the insured is a partner18 — which raises another question, namely, whether life insurance that is owned by a partnership in which the participant is a partner is includable in the participant's gross estate.19
Another approach is for the participant to sell the policy, for its fair market value, to a “defective grantor trust,” that is to say, a trust that is deemed to be “owned” (for income tax purposes) by the participant under the “grantor trust rules.”20 The theory is that a transaction between the participant and his grantor trust is not treated as a sale (and therefore, there is no transfer for value) because the participant and the trust are regarded as “one taxpayer” for income tax purposes.21
While the income tax rules22 determine the policy's value for purposes of a sale or distribution of the policy to the participant himself, they do not purport to apply to a sale of the policy to the beneficiaries (whether the sale is made by the participant or by the plan). If the participant is in poor health and would not, at the time of the sale to the beneficiaries, be insurable at the same rates that applied when the policy was issued, the IRS may raise questions regarding the sale if cash surrender value or policy reserves are used to establish the price. A bargain sale could result in a taxable gift.
Another concern is the prohibited transaction rules of ERISA. The Department of Labor's class exemption has already been discussed23; it exempts the sale of a life insurance policy by the plan from various prohibited transaction rules if certain requirements are met. If the sale is to someone other than the participant, and would be a prohibited transaction if not exempted, several additional requirements must be met.
As this discussion shows, there are quite a few IRS and DOL potholes that must be carefully navigated to implement some of the often-recommended strategies for plan-owned life insurance.
RISKS
A danger with this technique is that to sell policies, some insurers may become overly aggressive in touting “temporarily depressed value” policies, and participants will buy these policies in their plans solely to take advantage of the artificially low value. The IRS may be expected to crack down on egregious “springing-cash value” policies. Parties to such transactions are risking ERISA violations and plan-disqualification issues.24
Although a QRP can own life insurance, a requirement of a valid IRA is that “[n]o part of the [IRA's] funds will be invested in life insurance contracts.”25 Thus, if the participant's funds are entirely in an IRA, he cannot use IRA money directly to buy insurance. If he wants to pay the acquisition cost of the policy with pre-tax dollars, he must “roll” the money from the IRA into a QRP. However, if he has no QRP available, more risky planning techniques may be suggested. For example:
If the IRA owner has a business, some planners recommend having the business start a QRP so that the IRA owner can roll his IRA money into it (and buy insurance), despite the many drawbacks of plan-owned insurance, and the costs and burdens of starting a QRP the participant would not otherwise want. If the goal is to use the depressed-value rollout, that goal raises questions about whether the newly created retirement plan really is “qualified.” It may not be if it was adopted with the deliberate intention of terminating it in a few years when the insurance policy value is depressed.26 This somewhat risky strategy becomes extremely risky if the IRA owner doesn't even have a business and is urged to start one solely for the purpose of adopting a retirement plan that is created solely to enable the purchase of life insurance.
Another, untested approach is for the IRA to own an interest in an entity (such as a partnership or LLC), which in turn owns the insurance policy. Even if the prohibited-transaction issues can be successfully navigated,27 there is no guidance regarding what degree of control by the IRA or what other factors might be considered sufficient to cause an entity-held life insurance policy to be deemed held by the IRA, causing disqualification of the IRA. If an IRA owns an equity interest in a non-publically traded investment entity (such as a family partnership), the assets held by the entity are generally deemed assets of the retirement plan (that is to say, the intervening entity is ignored) for purposes of determining who is a fiduciary of the plan's assets.28 The IRS has never suggested applying this “plan assets” concept for purposes of Section 408(a)(3), but they might do so someday. Unless the IRS perceives severe abuse, such a rule would presumably be prospective only.
NON-TAX ADVANTAGES
Even aside from the idea discussed above that might save taxes, and despite the many complications of buying insurance in a plan, there are good reasons why a person would buy life insurance inside a retirement plan.
For example, if the participant is rated or uninsurable and wants to buy insurance, there may be a policy available through the plan that the client can purchase without evidence of insurability. Or the plan may have a negotiated group-insurance rate that is lower than the participant could obtain by buying insurance outside the plan. It is possible in some cases that the purchase of insurance, as an “incidental benefit,” could increase permitted contributions to a defined-benefit plan (or help absorb some funds in an overfunded defined-benefit plan).
The ultimate reason to buy insurance in a retirement plan is if the participant needs life insurance but has inadequate funds to pay for it outside the plan. While it is still advisable to look at the possibility of taking some money out of the plan to buy the insurance (especially if estate-tax reduction is a major goal), there is often a reason the participant cannot get money out of the plan easily (such as an unacceptable level of tax on plan distributions, or creditor or marital problems). In some cases, the plan doesn't permit this).
Endnotes:
Sanderson, M., “Pension Rescue: Using Trapped Dollars for Estate Planning,” Trusts and Estates, May 2003.
See next section of this article and Note 3.
For how to compute the amount of life insurance protection, and how to compute the value of that protection, see Treas. Reg. Section 1.402(a)-1(a)(3), Section 72(m)(3)(B), Section 1.72-16(b) and IRS Notice 2002-8, 2002-4 I.R.B. 398.
This is one of the constellation of plan-qualification requirements known as the “incidental benefit rule,” the gist of which is that a retirement plan is supposed to provide retirement benefits, and may provide other or additional benefits only to the extent that they are “incidental.” See Rev. Rul. 54-51, 1954-1 C.B. 147, as modified by Rev. Ruls. 57-213, 1957-1 C.B. 157 and 60-84, 1960-1 C.B. 159. The IRS has never defined “retirement.”
IRC Section 72(t).
IRC Section 408(a)(3).
IRC Section 402(c)(6)(A).
Treas. Reg. Section 1.402(a)-1(a)(1)(iii).
Reg. Section 1.72-16(b)(4). Some speculate that the IRS will disallow the use of accumulated Current Insurance Cost as “basis” when it issues the “further guidance” promised in Notice 2002-8.
Treas. Reg. Section 1.402(a)-1(a)(2).
IRS Notice 89-25, 1989-1 C.B. 662, Q&A 10.
See Employee Retirement Income Security Act of 1974 (ERISA) Section 406(a) (29 U.S.C.Section 1106(a)), ERISA Section 3(14) (29 U.S.C. Section 1002(14)) and IRC Section 4975.
PTE 1992-6, 2/12/92, 57 Fed. Reg. 5190; amended Sept. 3, 2002, 67 Fed. Reg. 56,313. This exempts the transaction from both IRC Section 4975 and ERISA Section 406.
RIA Pension & Profit Sharing 2d ¶ER 408-4.15. The author has been unable to locate this DOL position in the text of PTE 92-6 as it is reproduced in RIA Pension & Profit Sharing 2d at ¶93,211.
IRC Section 2035(a).
Because of the “exclusive benefit rule” of IRC Section 401(a)(2).
IRC Section 101(a)(2).
See IRC Section 101(a)(2)(B).
See IRC Section 2042, Rev. Rul. 83-147, 1983-2 C.B. 158 and PLY 200214028.
IRC Section 671-Section 677.
See Rev. Rul. 85-13, 1985-C.B. 184.
IRS Notice 89-25, 1989-1 C.B. 662, Q&A 10.
PTE 1992-6, Feb. 12, 1992, 57 Fed. Reg. 5190; amended 9/3/02, 67 Fed. Reg. 56,313.
For a discussion of these risks, see “Fully Insured (412(i)) Pension Plans: the Good, the Bad and the Ugly,” by John J. McFadden and Stephan R. Leimberg, Estate Planning, 2003. In the author's view, purchase of a reasonably priced life insurance policy does not create violation-of-fiduciary-duty problems even if it is anticipated that the policy will decline in value and will be distributed to the participant at its lowest point of value. Retirement plans are permitted to provide incidental death benefits, and accordingly must be permitted to pay a reasonable cost for providing such death benefits.
IRC Section 408(a)(3).
See “Fully Insured (412(i)) Pension Plans: The Good, the Bad and the Ugly,” by John J. McFadden and Stephan R. Leimberg, Estate Planning 2003.
See “Under What Circumstances Can an IRA Invest in a Business Owned in Part by the IRA Owner and Members of the IRA Owner's Family,” Oct. 17, 2001, by Noel C. Ice, Esq., published on his Web site www.trustsandestates.net/IRAsFLPs/IceSwanson.htm
DOL Reg. 29 CFR Section 2510.3-101.
