Life insurance needs are not always constant. They may evolve over time as families encounter various financial situations.
This is true for both individuals and the companies they own. However, when life insurance is held within a qualified retirement plan, questions often arise regarding exit strategies upon terminating the plan.
What is considered a sale or disposition? What are the tax consequences? Under what circumstances is a rollover considered tax-free? Are there any tax considerations when a policy is transferred between a shareholder or employee and the business? In this post, we will answer these questions.
There are four main exit strategies, although there are variations within each category. However, it is essential to note that the life insurance policy must be removed from the plan when retiring.
#1 – Buy Life Insurance Out of Plan
An alternative but still valid exit strategy involves the purchase of a life insurance policy from the insured’s funded grantor trust. This approach offers the advantage of avoiding the potential application of the three-year look-back rule if the participant decides to transfer the policy into a life insurance trust.
Although ERISA prohibits transactions between a participant and a pension plan, there are exceptions. A grantor trust created by the plan participant is treated as a sale to the insured rather than a prohibited transaction. A transfer-for-value consideration is not an issue since the grantor trust is considered the insured to apply the primary exception to this rule.
To purchase the contract from the plan, the plan may sell the insurance contract to the participant. However, to facilitate this sale, the contract must be surrendered by the plan.
The sale can also be made to a relative of the insured individual, a trust, or a family partnership. The amount paid to the plan for the contract must be equal to the fair market value of the property.
If the contract is purchased at its fair market value, no taxes will be owed on the transfer. However, if it is determined that the life insurance contract was obtained at a bargain price, the difference will be treated as a taxable distribution.
The cash paid by the participant for the policy will now be considered part of their retirement benefits in a defined contribution plan and can be distributed or rolled over into an IRA along with the rest of their plan benefits. In a defined benefit plan, if a lump sum is distributed, the participant will receive cash instead of the policy.
#2 – Roll Over Cash Surrender Value Into IRA
A common option is to surrender the contract within the plan and roll over the proceeds into an IRA. This is especially true if the client has no interest in maintaining the insurance policy. The client will simply terminate the policy and roll the cash render value over into an IRA or other qualified retirement plan. This is a tax-free rollover, but it will terminate the insurance provisions.
This option can work well if the client no longer needs or desires insurance coverage and no longer wants to make any premium payments. The value of the insurance can now be invested in stocks, bonds, or mutual funds. While the funds are maintained in the IRA or qualified plan, they continue to be tax-deferred and will only be subject to tax once it is distributed at some point in the future.
With this approach, the life insurance contract will be surrendered and there is no longer a death benefit. The remaining cash value will be consolidated with other plan assets.
#3 – Take Cash Surrender Value Out
Alternatively, the policy can be purchased directly from the plan. The fair market value (FMV) rules would still apply in this case. Since a sale does not trigger a taxable event, avoiding income taxes and the 10% penalty may be possible. The plan would continue to be funded with the proceeds from the sale. This strategy assumes that the participant has the necessary cash on hand to make the initial purchase. Additionally, the policy values can be utilized to help offset the impact of this strategy on cash flow.
If the client desires, they can terminate the policy and distribute the cash surrender value of the policy out of the plan. The downside of this is that it will result in immediate taxation.
While this is not the most tax efficient strategy, if the client has recently retired and is in a lower tax bracket, this might be an efficient strategy, depending on the cash value of the plan.
If the plan permits, the contract can be distributed in-kind. The life insurance contract may be transferred directly to the participant. This process involves the Trustee changing the ownership of the life insurance contract from the Trust to the individual. It is essential to obtain spousal consent prior to this distribution.
Once the individual owns the life insurance contract, a taxable event occurs. The individual will be taxed on the fair market value of the contract at the time of distribution. There is no option to defer the tax on the life insurance contract, and it cannot be transferred to an IRA for further tax deferral. The client will receive a 1099-R for the gross proceeds at the end of the year.
An outright taxable distribution to the plan participant is often possible, but any distribution taken before age 59½ may be subject to a 10 percent early distribution penalty unless an exception applies. Following this distribution, the plan would no longer include the policy. However, this might be a minor consideration if the participant is no longer insurable or has a high-risk rating.
How to Value Life Insurance Upon Termination
Tax law generally requires that a life insurance policy be valued at its Fair Market Value (FMV). FMV is typically defined as the cash value of the policy, along with the value of all rights under the contract, including any supplemental agreements, whether guaranteed or not.
The definition provided is somewhat vague, so the IRS introduced a safe harbor formula in Revenue Procedure 2005-25 to help determine the FMV of a life insurance policy in specific situations. It’s important to note that while this procedure offers a safe harbor approach, taxpayers are not required to use this formula to calculate the FMV. They are free to choose an alternative method for determining the FMV, but doing so may increase the risk of facing challenges from the IRS.
Whenever a life insurance policy is distributed or sold from a qualified plan, its value must be determined. Before February 13, 2004, the “value” of a life insurance policy was defined as either the policy’s cash surrender value or, in certain cases, the policy reserves.
Is a Cash Balance or Defined Benefit Plan Right For You?
However, the IRS became concerned about the use of so-called “springing cash value” policies, which had very low cash values at distribution that would later increase significantly. As a result, after February 12, 2004, the value of these policies is determined based on their “fair market value,” which includes the policy’s cash value, and all other rights associated with the contract.
Rev. Proc. 2005-25, 2205-17 I.R.B. 962, outlines a safe harbor formula for valuing life insurance policies. According to this formula, the safe harbor value of a policy is defined as “the greater of A or B.”
“A” represents the sum of the interpolated terminal reserve (a figure that must be obtained from the insurance company), any unearned premiums, and a pro rata portion of a reasonable estimate of dividends expected to be paid during that policy year based on the company’s experience.
“B” varies depending on the type of policy and can be summarized by the formula “PERC,” which stands for Premiums + Earnings – Reasonable Charges. This total is then multiplied by a permitted factor for surrender charges.
The formulas effectively prohibit excessive, waivable, or “disappearing” surrender charges from being used to offset the value of the policy. The “greater of A or B” formula is used to establish the fair market value of the policy.
Final Thoughts
You can buy life insurance through certain qualified retirement plans, which allows you to pay premiums using pre-tax dollars from your existing retirement funds. However, there are many strict rules that must be followed, making the process complicated and potentially costly.
Although the formula outlined in Rev. Proc. 2005-25 serves as a safe harbor, it is not mandatory. Taxpayers have the option to assess fair market value by using a different method, such as obtaining an appraisal from an independent company that specializes in evaluating insurance policies.
In many cases, it may be more beneficial to purchase an individual life insurance policy instead. It’s advisable to consult with both an insurance expert and a retirement plan specialist before proceeding with this approach.
