By Tim Mezhlumov, CFP®, CLU®, CFS, EA, director, advanced markets, 1st Global
One of the advantages offered by qualified retirement plans is the ability to acquire life insurance on plan participants using existing plan assets and future contributions to pay the premiums. This allows the plan to obtain life insurance coverage on plan participants with tax-deductible dollars. One stipulation is that this feature has to be offered to all plan participants. With self-directed 401(k) profit sharing plans, the decision should be needs-based – meaning the coverage should be obtained only on those participants who need it and wish to have it.
The qualified plan is the owner of the policy and the participant is the insured. The participant has the right to name a beneficiary – typically the spouse and/or the children of the participant.
Potential prospects for permanent life insurance-based qualified retirement plans include the following:
- Business owners who would like to purchase life insurance with tax-deductible dollars
- Individuals seeking to maximize retirement plan contributions and deductions (see discussion about 412(e)(3) plans below)
- Individuals who are adversely rated and for whom the tax deduction may help offset the higher premium cost
- Individuals in need of life insurance and a retirement savings program who have a limited budget
- Business owners interested in funding a buy/sell agreement with tax-deductible dollars utilizing a profit sharing plan. Note: The surviving business owner can be named the beneficiary on the policy providing the funds needed to purchase the business interest from the estate of the deceased business owner.
401(k) Profit-Sharing Plans
Regulations allow for up to 25 percent of the employer contribution amount to be used to pay life insurance premiums if utilizing term, universal or variable universal life insurance. This limitation goes up to 50 percent of contribution amount if whole life insurance is used, and the limitation does not apply to the employee salary deferral component.
Defined Benefit Plans
Traditional defined benefit plans do not restrict the type of policies that can be used, so universal or variable universal life policies may be utilized in conjunction with mutual funds. With a fully insured 412(e)(3) defined benefit plan, the regulations mandate using whole life insurance in conjunction with a fixed annuity. These plans allow business owners who are close to retirement age to maximize retirement plan contributions.
The “50 percent test” limits the life insurance premium amount to no more than 50 percent of contributions and forfeitures to an individual participant in 412(e)(3) defined benefit plans. The remaining 50 percent must be invested in a fixed annuity. In addition, the “100-to-1 rule” limits the death benefit to no more than 100 times the plan participant’s monthly retirement benefit.
Employee Stock Ownership Plan
An Employee Stock Ownership Plan (ESOP) is a qualified defined contribution plan in which contributions are primarily invested in employer stock. ESOPs may be utilized for business succession purposes by a company with a capable management team and an owner who is unable or unwilling to sell the company to a third party and has no heirs capable of running the company.
The company owner sells his stock to the ESOP usually under an installment sale. The plan trustee typically acquires a life insurance policy on the seller to fund the stock repurchase agreement, which is necessary in case the owner dies before the installment sale obligation is fully satisfied by the plan. This enables the plan trustee to pay off the remaining note balance and the owner’s estate will receive that amount as a lump sum payment.
Since life insurance premiums are paid with qualified plan dollars, they are deductible to the company. However, adding life insurance to the plan may cause the plan participant to incur income tax liability on the cost of the economic benefit which is the pure insurance protection. The cost of economic benefit is determined by referencing IRS Table 2001 and is typically calculated by the insurance company.
If the participant dies prior to retirement, a portion of the proceeds is likely to be subject to income tax and the entire death benefit will be included in the insured’s estate. The amount subject to income tax equals the cash value at the time of death. The tax-free amount is the “net amount at risk” – this is the difference between the death benefit amount and cash value.
If the participant retires, one option is to surrender the policy and have the proceeds rolled over to an IRA. If the insurance is still needed the participant may purchase the policy from the plan. The purchase price amount typically equals the cash surrender value. Once the policy is purchased from the plan, it will be subject to the same rules and tax treatment as a policy purchased with non-qualified dollars. Alternatively, the policy can be purchased by an irrevocable life insurance trust which would avoid having the death benefit proceeds included in the client’s estate.
Disadvantages of Owning Life Insurance in a Qualified Plan
Potential disadvantages of purchasing life insurance in a qualified plan include the following:
- The ability to pay premiums may be dependent on the ability to make retirement plan contributions
- Since the retirement plan is primarily for the benefit of the plan participant, IRS code mandates that the survivor’s benefit must be merely incidental to the retirement benefit with a cap on the amount of life insurance that can be obtained
- If the plan participant dies prior to retirement, the policy will be included in his or her estate
- The policy will have to be purchased, surrendered or distributed to the participant at retirement or plan termination (an IRA cannot own life insurance so it is not possible to roll over the policy to an IRA)
- The closer the individual is to retirement the higher the cash value and consequently the amount needed to purchase the policy from the plan
Utilizing life insurance in a qualified plan requires careful retirement plan design analysis and policy selection, so it is important to work with qualified providers. At a minimum, this will include a third-party administrator (TPA) and retirement plan consultant or financial advisor who is familiar with insurance-based qualified retirement plans.
Tim Mezhlumov is Director of Advanced Markets at 1st Global, a research and consulting partner for high-achieving CPA firms offering wealth management. 1st Global provides CPA, tax and estate planning firms the education, technology, business-building framework and client solutions that make these firms leaders in their professions through dedicated professional client relationships built around wealth management.
1st Global Capital Corp. is a member of FINRA and SIPC and is headquartered at 12750 Merit Dr., Suite 1200 in Dallas, Texas, 75251; 214-294-5000. Investment advisory services offered through 1st Global Advisors, Inc., an SEC-Registered Investment Adviser. Additional information about 1st Global is available at www.1stGlobal.com
Certified Financial Planner Board of Standards Inc. owns the certification marks CFP®, CERTIFIED FINANCIAL PLANNER™ and federally registered CFP (with flame design) in the U.S., which it awards to individuals who successfully complete CFP Board’s initial and ongoing certification requirements.