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.
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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).
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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.
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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.Looking for more information on cash balance plans? Take a look at our ultimate guide to cash balance plans. Discover our favorite strategies!
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.