One of our favorite things to do is to implement creative tax and retirement structures for our clients. That’s why we’re going to discuss the twist on a very basic plan that we do. We’re going to talk about pension plan life insurance.
If you are a high-income business owner and you’re looking to fund retirement along with a life insurance policy, we’ve got a couple of options for you. There are some pitfalls to these plans. But if implemented correctly, they can be an excellent financial planning tool.
Using a qualified plan to assist in purchasing life insurance necessary to address personal insurance needs is a unique technique that will only be available or appropriate for some clients.
How does life insurance in a pension plan work?
Including life insurance in a pension plan can make a lot of sense. But it depends on the client’s situation. Let’s list below a few of the advantages:
- It allows the life insurance coverage to be tax deductible because it’s part of a tax-deductible qualified plan contribution.
- It provides an incidental benefit in addition to any retirement plan benefits.
- Including life insurance in the plan will provide higher overall tax deduction deductible contributions over the life of the pension plan.
- It allows a tax-free benefit to the family or other beneficiaries in the event of the plan participant’s death.
- Assuming the employee survives until retirement, the insurance policy can provide for tax-free distributions during retirement years.
- Suppose the insurance is subsequently removed from the plan and transferred to an eyelet. It provides a powerful estate planning tool.
- Any contributions made to the pension, including the life insurance premiums, are tax-deductible by the company.
- Because the pension plan owns the policy, the plan will allow for the insured death benefit and any retirement benefits. If the participant passes away while the policy is in the plan, the death benefit is paid from the insured to the pension plan. The pension plan can then pay an amount equal to the death benefit less any cash surrender value to the beneficiary. Again, this death benefit is tax-free to the beneficiary. The cash surrender value plus any assets from the brokerage account up to the retirement benefit can be rolled over to an IRA for the beneficiary.
- Before retirement, the plan can allow the participant to acquire the policy from the plan at its fair Vark market value. This can also be done at retirement or termination of employment. Once the insurance is outside the plan, the participants can access the cash surrender value to take tax-free retirement income. The policy can often be purchased by an ILIT that can assist with estate planning.
The plan must provide insurance to any qualified participants to satisfy the IRS requirements. However, using a cash balance plan structure allows you only to include two participants in the cash balance plan, which will enable the remaining employees to be excluded from plan contributions and insurance premiums.
What is a pension plan?
A pension plan is a type of retirement plan in which an employer promises to pay retirement benefits to employees based on a predetermined formula. Employer contributions typically fund pension plans and may also require employee contributions in some cases.
The benefit formula used in a pension plan typically considers factors such as an employee’s salary, years of service, and age at retirement. The formula may also provide additional benefits based on disability or death. The benefit amount is usually paid to the employee in regular payments, often for the remainder of their lifetime.
Pension plans may be either defined benefit plans or defined contribution plans. The employer bears the investment risk in a defined benefit pension and ensures the plan is adequately funded to meet its future benefit obligations. In a defined contribution plan, the employee bears the investment risk and is responsible for making investment decisions with the funds contributed to the plan.
Pension plans are subject to various legal and regulatory requirements, such as the Employee Retirement Income Security Act (ERISA) and Internal Revenue Service (IRS) guidelines. These regulations help ensure that pension plans are adequately funded, provide fair benefits to employees, and are administered transparently and accountable.
Who is a great candidate?
The inclusion of life insurance in a qualified plan may provide benefits to the owner(s), as well as other plan participants, of virtually any form of business entity — sole proprietorship, partnership, S-Corporation, C-Corporation or LLC — provided one or more of the owners have a significant need for life insurance.
| Pros | Cons |
|---|---|
| Flexible Contribution Range | Mandatory Contributions |
| Tailored Plan Structure | High Plan Set Up Fees |
| Tax-Deferred Funding | IRS Permanency |
| Easy Rollover Options | No Employee Deferral |
Of course, if a qualified plan offers life insurance, all plan participants can elect to utilize it. It may be especially advantageous for business owners who meet any one or more of the following criteria:
- Are the sole owner of a service business — These businesses typically have no market value upon the retirement or death of the owner, so the qualified plan, including life insurance, can provide the liquidity and exit strategy that would otherwise be found only in an insured buy-sell arrangement.
- Age 50 or older — They are likely more sensitive to their life insurance needs, not because life insurance is less advantageous for younger business owners.
- Can influence employee retirement plan decisions — The decision to include life insurance will likely be made by the business’s majority owner(s).
- Face estate tax and planning issues Business owners who, in addition to meeting the criteria, have considerable assets in IRAs, rollover IRAs, or other qualified plans may benefit the most, as they may be able to use these assets to fund a significant portion or perhaps even the entirety of their life insurance needs
How can you use life insurance for retirement?
Life insurance is often used as a retirement planning tool in several ways. Here are a few examples:
- Cash value life insurance: Clients use cash value life insurance policies, such as universal life insurance and whole life insurance, to provide both a death benefit and also a cash value component that grows over time. The cash value can be accessed through withdrawals or loans, which can be used to supplement retirement income. The policy owner can also choose to surrender the policy for its cash value, which can provide a lump sum payout.
- Annuities with death benefits: An annuity is essentially a contract between a person and the insurance company to provide a guaranteed income stream in retirement. Some annuities offer a death benefit option that guarantees a payout to the beneficiary if the annuity owner dies before the annuity payments have begun. This can provide a form of retirement income replacement for the beneficiary.
- Long-term care insurance: Many professionals use long-term care insurance can be structured to cover the costs associated with long-term care, such as nursing home care, home health care, or assisted living. Some life insurance policies offer long-term care insurance riders, which can provide a source of funding for long-term care expenses in retirement.
- Estate planning: Life insurance can be used as a tool for estate planning by providing a source of liquidity to pay estate taxes or other expenses. This can help to preserve other assets for heirs or beneficiaries.
It’s important to note that life insurance should be part of a comprehensive retirement plan that considers individual goals, needs, and financial circumstances. Consultation with a financial advisor or insurance professional can help determine the best approach for using life insurance as a retirement planning tool.
IRS rules for pensions
- Nondiscrimination rules: Cash balance plans must meet nondiscrimination rules to ensure they do not disproportionately benefit highly compensated employees. To meet these rules, the plan must pass a “comparability” test, comparing the benefits provided to highly compensated employees to those offered to non-highly compensated employees.
- Minimum vesting requirements: Cash balance plans must meet minimum vesting requirements to ensure that employees are entitled to a certain percentage of their account balance if they leave the company. The vesting schedule for a cash balance plan is typically based on years of service, with a certain percentage of the account balance vesting each year.
- Maximum annual contribution limits: Cash balance plans are subject to maximum annual contribution limits, which the IRS sets to ensure that the benefits provided under the plan are reasonable. The maximum annual contribution limit is the lesser of (a) 100% of the participant’s salary or (b) the maximum yearly contribution limit for defined contribution plans, as established by the IRS.
- Annual benefit limits: Cash balance plans are also subject to annual benefit limits, the maximum amount that an employee can accrue in benefits under the plan each year. The annual benefit limit is less than (a) $230,000 or (b) 100% of the employee’s average compensation for the highest three consecutive years.
