Cash balance plans are our favorite defined benefit plan structure. They work for great for many high-income business owners.
But did you know you can put life insurance in a cash balance plan? In fact, very few CPAs and financial advisors even understand how this works.
This guide will discuss how this structure works and offer up a few tips and tricks along the way. In the right situation, this structure can be a home run. But if done incorrectly, they can result in a few pitfalls. Let’s get started.
How is life insurance taxed in a qualified plan?
When a qualified plan owns a life insurance policy, the policy is divided into two parts for tax purposes: the cash value portion and the pure insurance portion. The cash value portion is an investment in the participant’s retirement account.
Even though it is part of the policy itself, the cash value is paid to the participant’s account at the insured’s death. The plan trustee distributes it as part of the group of assets invested for the participant’s retirement.
The pure insurance portion is deemed to be separate. It alone is controlled by the participant’s policy beneficiary designation. Only this portion of the policy death benefit is paid to the named policy beneficiary income tax-free under IRC Section 101 at the insured’s death.
The pure death benefit protection is valued based on the insured’s age according to IRS Table 2001 or, in certain circumstances, using the insurance carrier’s published one-year term rates. The cash value portion is not included in the calculation and has no income tax consequences while the insured is alive.
Sole proprietors and partners in partnerships are not required to report the annual economic value of the death benefit as taxable income. Instead, the business is not permitted to take a deduction for the portion of the plan contribution equal to the cost of the annual death benefit protection.
The participant is entitled to count the annual value of the death benefit taxed to them as basis. Thus, the participant’s basis in the policy is the cumulative total of the values reported over the years on his/her income tax returns. If the participant makes nondeductible contributions to the plan, those contributions increase their basis.
Are death payments from a qualified retirement plan exempt from tax?
Assuming the participant has included the costs of life insurance protection as an element of current income, the portion of the life insurance proceeds payable at death that is more than the policy’s cash value immediately before death will be excluded from the recipient’s income under IRC § 101(a).
Additionally, a portion of the benefits received from the policy equal to the aggregate amount of income recognized as economic benefits for the cost of life insurance will be treated as basis in the plan and thus can also be received income tax-free.
All of the remaining death benefits – i.e., the portion equal to the cash value of the policy immediately before death minus the aggregate economic benefits recognized as income – will be treated as a taxable distribution of plan assets and treated as income in respect of a decedent (or “IRD”).
The insurance policy has a $300,000 face amount and a cash surrender value of $100,000. The participant has been paying tax annually on the cost of life insurance and has recognized aggregate economic benefit income of $10,000.
The policy’s $300,000 death benefit would be paid directly to the participant’s spouse should the participant die. In addition, $200,000 would be excluded from income as a death benefit payable under IRC § 101(a).
The remaining $100,000 will be treated as a plan distribution. However, $10,000 will be excluded from income as a basis adjustment created by recognizing the economic cost of the life insurance protection in the participant’s cumulative annual income. As a result, the participant’s spouse must recognize $90,000 of income from the policy death benefits as IRD.
Options for continuing life insurance coverage at retirement
Once a participant is no longer an active plan sponsor employee, a qualified retirement plan may generally no longer hold the life insurance policy as a plan asset. A participant who wants life insurance protection to continue after termination of employment has two options:
- take the policy out of the plan as a plan distribution; or
- allow the plan to sell the policy to the participant or a permissible third party.
Receiving the life insurance policy as a plan distribution
If the participant desires to keep the life insurance coverage in force after terminating employment, and if permissible under the plan terms, the policy may be transferred from the plan to the participant as a plan distribution.
The fair market value of the life insurance contract must be included in the participant’s income to the extent it exceeds the participant’s basis in the contract. For this purpose, the participant’s basis consists of any non-deductible premium payments he or she made towards the life insurance contract and the amount of economic benefit income recognized for the cost of life insurance protection.
Understanding how to use qualified plan funds to purchase life insurance can add a new dimension to your retirement account. When you can see how to pay for insurance premiums without changing your cash flow or lifestyle, it may open the door to new opportunities. Many adults participate in qualified plans, so the potential opportunity is substantial.
Business owners who don’t want to pay insurance premiums personally or who don’t want to pay premiums for key employees with after-tax dollars, can set up a qualified plan or possibly amend their current plan so that pre-tax funds can be used. Ensure that you consider this specific opportunity. In the right situation, it can be a home run.