Life Insurance in a Cash Balance Plan: 3 Simple Steps

A significant advantage of qualified retirement plans is the fact that they can utilize life insurance for plan participants. The plan can use any current plan assets in additional to future retirement contributions to pay for the premiums. Accordingly, life insurance in a cash balance plan can be a great option.

Using this strategy, the plan can acquire life insurance coverage on plan participants using tax-deductible dollars. However, one important consideration is it has to be offered to all plan participants and cannot be only offered to key employees.

In this post, we will show you a few life insurance strategies. Let’s dive in!

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The qualified plan itself becomes the owner of the insurance policy and the participant becomes the insured party. In addition, the participant can name a beneficiary (often the spouse or the children of the plan participant).

There are many prospects who would consider life insurance-based qualified retirement plans. The following may be a good fit:

  • Entrepreneurs and business owners who desire the benefits of life insurance and also desire the tax deduction;
  • Individuals who would like to maximize retirement plan contributions (see discussion about 412(e)(3) plans);
  • Individuals who may not have the best rating and would like the tax deduction to offset the increased premium costs;
  • Individuals who would like life insurance combined with a retirement plan and are on a limited cash budget;
  • Business owners who would like to fund a buy/sell agreement and get a tax deduction. In this case, the surviving business owner would be the beneficiary on the policy which would provide the cash requirements to acquire the business interest from the estate of the deceased business owner.

Step #1: How Does Life Insurance in a Cash Balance Plan Work?

Traditional defined benefit plans and cash balance plans do not place restrictions on the type of insurance policies that can be utilized. As such, universal or variable life policies can be utilized along with mutual funds and other investments. In a fully insured 412(e)(3) defined benefit plan, the plan is required to use whole life insurance along with a fixed annuity. The plan allows business owners to maximize retirement plan contributions, which may be especially beneficial if the owner is approaching retirement.

But there is a special rule that needs to be considered. The “50 percent test” will limit the life insurance premium to no more than 50 percent of contributions and forfeitures to an individual participant in 412(e)(3) defined benefit plans. The other 50 percent must be invested in a fixed annuity.

But there is another rule to consider. The “100-to-1 rule” will limit any death benefit to no more than 100 times the related plan participant’s monthly retirement benefit.

Step #2: What About Taxes?

One of the advantages of a cash balance plan is the tax benefits it offers, both for employers and employees. Employers who wish to offer a cash balance plan can deduct any contributions from their taxable income, resulting in less taxes paid for any given year.

Employees likewise don’t pay any taxes on the contributions until they reach retirement age and begin taking distributions.  The growth of the funds within the account grow tax deferred, so no annual taxes are paid on the growth of the funds.

Because the life insurance premiums are paid with funds from inside the qualified plan, they are tax deductible by the company. But the addition of the life insurance can result in a tax liability to the plan participant based on the cost of the economic benefit (the insurance protection). The actual economic benefit is determined by utilizing IRS Table 2001. Generally, it is calculated by the TPA or the insurance company.

So what happens if the plan participant dies prior to retirement? The tax situation gets a little tricky. A portion of the insurance proceeds would likely be subject to taxation and the entire death benefit would be included in the insured’s estate. The taxable amount would equal the cash value at the date of death. The tax-free amount is based on the “net amount at risk”. This is calculated as the difference between the cash value and the death benefit amount.

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So what happens when the participant retires? One popular option is to surrender the insurance policy and have all cash proceeds rolled over to an IRA. If the participant still needs insurance, the participant can purchase the policy itself from the plan. The purchase price of the policy is generally the cash surrender value.

Assuming the policy is acquired from the plan, it is subject to the same rules and tax treatment as any policy that was purchased with non-qualified funds. But one option is to have the policy purchased by an irrevocable life insurance trust. If structured correctly, this would avoid having any death benefit proceeds included in the participant’s estate.

Step #3: Life Insurance Inside a Cash Balance Plan: Other Considerations

There are many benefits to life insurance in a cash balance plan. But there are a few pitfalls. Make sure you consider the following:

  • There must be adequate funds to make retirement contributions because the payment of insurance premiums is dependent on it.
  • As the retirement plan is established primarily for the benefit of the participant, IRS code requires that the survivor’s benefit is incidental to the retirement benefit and there is a cap on the total amount of life insurance that can be obtained inside the plan.
  • Again, if the participant dies prior to retirement, the policy is included in the estate. This could result in negative tax consequences including federal or state estate tax.
  • An IRA is prohibited from owning life insurance. The insurance policy will be required to be surrendered, purchased, or distributed to the participant at retirement or at plan termination.
  • The closer the participant is to retirement the higher the cash value will be and, accordingly, the higher the amount required to purchase the policy from the retirement plan.

Utilizing life insurance in a cash balance plan can be an excellent option. But it requires careful plan design and the proper coordination between the financial advisor, tax professional and TPA.

Advantages of Life Insurance in a Qualified Plan

  • Personal cash flow is improved: The employee doesn’t have to use personal out-of-pocket dollars to pay premiums.
  • Tax efficiency is increased: Premiums are paid with pre-tax dollars; efficiency is increased if the employee’s health is poor or the policy is rated.
  • The employee doesn’t have to administer the policy: The plan trustee must administer it.
  • The employee can obtain the desired life insurance coverage without worrying about the premium cost.

Disadvantages of Life Insurance in a Qualified Plan

  • There is a cost for the coverage: The value of the pure term insurance element is taxable income annually.
  • When the employee retires or changes jobs, the plan may not continue to be able to own the policy. Depending on the plan document’s provisions, it may have to be surrendered or transferred to the employee in a taxable distribution.
  • When the qualified plan pays the employee’s life insurance premiums, the value of other investments in the account may be reduced, providing fewer assets for distribution during retirement.
  • If the policy has cash value, the cash value portion will not be distributed income tax-free to the policy beneficiary. Instead, it remains in the plan and is distributed by the plan trustee to the employee’s designated beneficiary as ordinary income.
  • The death benefits may be included in the employee’s estate for federal estate tax purposes.

Removing the Policy from the Plan at Fair Market Value

Generally, the policy cannot stay in the qualified plan after the employee retires, changes jobs, or ends their participation in the plan. If the employee needs or wants to maintain the policy, it must be removed from the plan at fair market value.

The IRS has issued regulations and other guidance designed to end abuses involving life insurance policies in qualified plans. The 2005 regulations create a uniform standard for valuing a life insurance policy when sold or distributed from a qualified plan.

Until the issuance of these regulations, it was generally assumed that the fair market value of a life insurance policy was its cash surrender value. These regulations typically define fair market value as the value of all rights under the policy, including supplemental agreements, whether or not guaranteed.

Revenue Procedure 2005-25 was issued to establish a safe harbor taxpayers could rely on in valuing policies sold or distributed from qualified plans. It establishes what is known as the PERC formula. Under it, fair market value is determined as follows:

The premiums paid from the date of issue to the date of distribution without reduction for dividends that offset those premiums, plus dividends applied to purchase paid-up insurance, plus any amounts credited or otherwise made available to the owner, including interest, dividends, or adjustments reflecting investment return and the current market value of segregated asset accounts, minus explicit or implicit reasonable mortality charges and reasonable other charges actually charged on or before the valuation date and those charges are not expected to be refunded, rebated or otherwise reversed at a later date, minus any distributions, withdrawals or partial surrenders taken before the valuation date.

Cash surrender values, reserves, or other measures of value may still be used, but only if they do not arrive at an amount significantly less than the aggregate of the formula components. If the participant uses cash surrender value to value the policy to the extent it is less than the fair market value under the IRS formula, the difference is regarded as a distribution from the plan contrary to PTE 92-6. As a result, the plan may become disqualified.

Why Purchase Cash Value Insurance in the Qualified Plan?

The qualified plan can purchase either term insurance or cash value insurance for a participant’s benefit. Term insurance makes sense if the participant does not believe they will need life insurance protection after retiring or otherwise leaving the plan. When this is the case, the policy can be allowed to lapse, and no death benefit coverage will continue.

It may be shortsighted, however, to assume at the outset that the participant will not need or want life insurance death benefits after retirement or termination. The future is difficult to predict. The circumstances at retirement may be different from those originally anticipated. For example, life insurance after retirement may be needed if:

  • Retirement investments did not perform or accumulate as expected.
  • Inflation and the cost of living are higher than assumed.
  • Retirement funds are limited, and the participant’s spouse will likely live beyond normal life expectancy.
  • The participant is in poor health with resulting medical expenses that could use up a large portion of the available retirement funds.
  • The participant has a child or grandchild with special needs.

Further, even if life insurance is not needed during retirement, it may still be wanted. The ability of life insurance to pay income tax-free death benefits allows it to be used in unique ways to provide an inheritance to children and grandchildren. It can also be used to make a bequest to a valued charity or social cause the participant wishes to benefit.

Cash value life insurance inside the qualified plan may give a participant more financial flexibility after retirement.

Paul Sundin

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