Life insurance needs are not always static. They can change and evolve over time as families face certain financial situations.
This is the case for both individuals and for the companies that they own. But when life insurance is held in a qualified plan, questions often arise regarding the tax consequences of transferring the policy out of the plan.
What actually consists constitutes a sale or disposition? Who is ultimately liable for any tax due? Under what situation is a rollover tax-free? What tax issues are associated with a transfer between a shareholder or employee and a business?
How to determine the fair market value of a life insurance policy?
Transferring an existing insurance policy to a new owner could be a solution in many situations. Whether it occurs during the policyholder’s lifetime, or even at death, or even as a part of a transaction involving various corporate entities, the tax concerns of the transfer can be challenging to assess.
Transferring a life insurance policy out of a qualified plan raises tax and legal concerns. The solutions will vary depending on the parties involved in the transaction. Whether the transaction is at an arm’s length will also affect the fair market value and the final outcome. In this guide, we will address some of these concerns and also discuss some specific examples to help illustrate the tax implications of these transfers. Let’s dive in.
When removing life insurance from a qualified plan, the administrator must determine the insurance policy’s fair market value (FMV). Determining the FMV of a life insurance policy is a changing dynamic. Although we can assist the client’s attorney and CPA, the approach and the final valuation are ultimately up to them.
Determining a Life Insurance Policy’s “Fair Market Value” Upon Distribution or Sale
For all distributions or sales from qualified retirement plans after February 12, 2004, the fair market value of a life insurance contract includes the policy cash value and all other rights under the contract. It is determined using the “PERC” calculation prescribed by the IRS in Rev. Proc. 2005-25.
In its 2005 guidance, the IRS indicates that for income tax purposes, a life insurance policy must be valued at the higher of (i) the interpolated terminal reserve value or (ii) the PERC value multiplied by an “Average Surrender Factor” (for which the IRS supplies a formula).82 Where the transfer is governed by IRC §§ 79 or 83, no adjustment to the PERC is allowed for policy surrender charges.
Insurance Exit Strategies
Upon retirement or when the company terminates the plan, there are several options regarding the life insurance held in the plan. With these specific options, the remaining fair value in the qualified plan can be rolled over to an IRA or another qualified plan:
- An irrevocable life insurance trust (ILIT) can purchase the insurance policy. If structured correctly, the death benefit will be free of income and estate tax.
- Transfer the ownership of the insurance policy to the insured. The policy’s cash value will have to be reflected as taxable income in the distribution year. If the insured is under age 59½, early withdrawal penalties may be applicable.
- Surrender the insurance policy, and the cash value continues to remain in the plan. However, in this situation, the insured is giving up the life insurance coverage.
- The policy could be sold to the insured or a grantor trust set up by the insured. As long as the policy is sold for fair value, there is no immediate tax liability. This allows the insured to continue to maintain the insurance coverage.
Once the insurance is out of the plan, the insured can make any specified changes to the coverage to meet their estate planning and retirement needs. However, some rules specify what family members who own more than 50% of a business are allowed to do when purchasing a life insurance policy from the qualified plan.
Safe Harbor Guidelines
Generally, tax law, requires a life insurance policy to be valued at its FMV. This FMV is generally defined as the policy cash value and the value of all rights under the contract, including any supplemental agreements and whether or not guaranteed.
Since this definition is vague, the IRS, in Revenue Procedure 2005-25, has provided a safe harbor formula for determining the FMV of a life insurance policy in certain situations. Note: This procedure offers a safe harbor approach, but taxpayers are not obligated to use this formula to determine the FMV. One is free to rely upon another method of arriving at the FMV, though they risk facing a challenge from the IRS.
Safe Harbor Formula
The IRS will generally accept the use of the safe harbor formula to establish the FMV of a policy provided that it is interpreted in a reasonable manner that does not understate the FMV. If an insurance policy has not been in force for some time, the value of the contract is best established through the premiums paid for that contract rather than the safe harbor formula.
Under the safe harbor formula, the FMV of a life insurance policy in a qualified plan is the greater of:
- Adjusted ITR. The sum of the policy’s Interpolated Terminal Reserve (ITR) and any unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year based on company experience; or
- Adjusted PERC Amount. The product of the PERC amount multiplied by the Average Surrender Factor. The PERC amount is generally equal to Premiums plus Dividends plus Other Earnings minus Reasonable Charges and Distributions.
How do qualified retirement plans work?
Qualified retirement plans are employer-sponsored retirement plans that meet specific requirements under the Internal Revenue Code. These plans offer tax advantages for both the employer and the employees.
Here’s how qualified retirement plans generally work:
- Employer contribution: The employer sets up a retirement plan and makes contributions on behalf of the employees. The contributions are typically tax-deductible for the employer.
- Employee contributions: Employees can also contribute to the plan through salary deferrals. These contributions are pre-tax, which reduces the employee’s taxable income.
- Investment: The contributions are invested in various investment assets, such as stocks, mutual funds, and bonds.
- Tax-deferred growth: The contributions and investment earnings grow tax-deferred until they are withdrawn in retirement.
- Vesting: The employer may have a vesting schedule, which determines how much employer contributions the employee is entitled to keep if they leave the company before retirement.
- Withdrawals: When the employee reaches retirement age (usually 59 1/2), they can begin to withdraw funds from the plan. The withdrawals are subject to income tax, but the tax-deferred growth means that the employee likely has more money in the plan than if they had invested after-tax dollars in a taxable account.
|Inside Plan||Outside Plan|
|Taxable Economic Benefit on 1099-R||No Premium Limitations|
|Must be Split Funded||Tax-Free Beneficiary Death Benefit|
|Tax Deductible Premiums||Cash Surrender Value Option|
|Incidental Benefit Rules||After-Tax Premiums|
Overall, qualified retirement plans offer tax benefits for employers and employees and can be an effective way to save for retirement. However, there are limits on how much can be contributed each year, and fees and other costs may be associated with the plan.
While life insurance can help qualified retirement plan participants to meet both retirement planning and income protection goals, those considering the purchase of life insurance within such plans need to understand the various rules and restrictions that are applicable to such an investment, including the “incidental benefit” limitations for various types of plan designs, the tax treatment of life insurance protection while participating in a plan, the tax treatment of death benefits when paid out, and the options for
continuing life insurance coverage at retirement.