In this post, we examine a little-known retirement strategy. We examine how you can put life insurance in a defined benefit plan. Let’s get started.
Qualified plans have an advantage of utilizing life insurance for their plan participants. Plan assets and future retirement distributions can be used to pay insurance premiums. Business owners under a defined benefit plan can take advantage of the life insurance option.
Tax-deductible dollars can be used to acquire life insurance. Sponsors should, however, comply with the non-discriminatory rule that life insurance acquired should benefit all plan participants and not just key employees.
Defined benefit plan owns the insurance policy while the participants become the insured party. Participants also have a privilege of adding a beneficiary to the insurance, normally a spouse or their children.
Best candidates for life insurance in a defined benefit plan?
If you fall under the following categories, you should consider taking a life insurance-based defined benefit plan. This is an excellent option for business owners and entrepreneurs who would like:
- the benefits of life insurance but are also in search of a significant tax deduction.
- to maximize the contribution to a retirement plan.
- to get a higher tax deduction when they have higher insurance risks that can offset any increase in premium payments.
- a life insurance policy combined with a retirement strategy and face a limited budget.
- to fund a buy/sell agreement along with a tax deduction. In this situation, the surviving business owner would be the beneficiary of the policy. This provides the cash required to purchase the remaining business interest from the estate of the deceased business owner.
Funding Life insurance in a defined benefit plan
Under defined benefit plan rules, one can utilize any type of insurance policies without restrictions. Universal or variable life policies can, therefore, be utilized in combination with stocks, mutual funds, bonds, CDs, etc. But an insured 412(e)(3) defined benefit plan is a little different. It is required to utilize a whole life policy in combination with a fixed annuity. Both plans enable business owners to make significant plan contributions. This is a great benefit for owners who are close to retirement age.
However, there are rules that should be followed in order to take advantage of life insurance. First, the “50% test” has to be adhered to. This rule restricts life insurance premiums to no more than 50 percent of total contributions.
The second rule is the “100-to-1” rule. This rule also limits any death benefit to no more than 100 times the related plan participant’s monthly retirement benefit.
What about the tax benefits?
Defined benefit plans are well known for their tax benefits, both to employers and employees. Contributions made towards a cash balance plan are deductible for business income, resulting in less tax payable in a given tax year.
Employees also enjoy deferred tax on contributions made until retirement age where they can pay less tax on distributions received. Any growth in the account balance grows tax-deferred, so no annual taxes are paid on the growth of the funds.
Any insurance premiums are of course paid with funds from the plan, meaning that they are tax deductible to the company. Plan participant should, however, be concerned of the additional tax liabilities associated with life insurance based on the cost of the economic benefit. The economic benefit is calculated by an actuary or an insurance company using an IRS Table 2001.
Should a plan participant pass away prior to retirement, a portion of the proceeds would typically be taxed and any death benefit is generally included in the decedent’s estate. Any tax liability would result from the cash value of the policy at the date of death.
Any tax-free proceeds are based on the “net amount at risk”. This would be determined based on the difference between the death benefit and any cash value.
When a participant retires, he has an option to surrender the insurance policy and have all cash proceeds rolled over to an IRA. He can also opt to proceed with the insurance by purchasing the policy from the plan. The policy purchase price is the cash surrender value.
A policy acquired has the same rules and tax treatment as any policy that was purchased with non-qualified funds. The best way to acquire a policy is to have an irrevocable life insurance trust purchase it. This generally prevents the inclusion of any death benefit insurance proceeds in the decedent’s estate.
Life Insurance in a Defined Benefit Plan: Other Considerations?
Before having a life insurance in a defined benefit plan, it is good to consider the following:
- There should be adequate funds available for retirement contributions because the insurance payments rely on them.
- Since the plan is established and maintained for the benefit of participants, the IRS requires that any survivor benefits are incidental to the ultimate retirement benefit. There is a cap placed on the total life insurance that can be included inside the plan itself.
- If any participant dies prior to retirement, the policy would typically be included in the participant’s estate. This could, however, result in federal (and even state) estate tax that may have been avoided.
- Remember that an IRA will be prohibited from owning a life insurance policy. So if a plan is terminated and rolled over, the policy must be purchased, surrendered or distributed to the employee.
- When an employee becomes closer to retirement the cash value will be higher. This of course results in a higher amount required to purchase the insurance policy from the plan.
Buying life insurance in a defined benefit plan is an excellent option especially for business owners who wish to maximize contributions and take advantage of tax deductions. A careful design is however required to ensure success.
You should have a financial advisor, tax professional, and a TPA who coordinate together and reduce the administrative burden on the business owner.