Life Insurance and Qualified Plans
Henry A. Deppe, CLU®
Henry A. Deppe, CLU® Former general agent of Guardian Life Insurance Company, Henry has served on the faculty at Purdue University, Farleigh Dickinson University and The American College.
The use of qualified plan funds to purchase life insurance has long been an option for those with a life insurance need. In some cases, limited liquidity dictates the use of such funds; in all cases, there can be significant tax and business advantages to funding life insurance needs through a qualified plan.
Premiums paid with qualified plan funds are paid with amounts not subject to income tax. As a result, the actual cost of paying the premiums is significantly lower than if after-tax funds are used. This can reduce the cash flow required to provide the benefit or permit the purchase of a greater amount of life insurance than would otherwise be possible. This also can permit the purchase of more secure forms of life insurance as the higher premiums are offset by the tax savings. With the tax leverage, it is less expensive to purchase insurance for individuals whose health is impaired because the additional cost for any rating is also paid with pre-tax funds.
While each year a policy is held in a plan an amount determined under IRS Table 2001 is taxed to the participant, this amount is usually a small portion of the actual premium cost, but in most instances the taxable amount constitutes basis to the heirs. This reduces any income tax on the death benefit and any tax should the participant receive a distribution of the policy.
When a participant dies, life insurance proceeds in excess of the cash value (and any basis in the policy) are received by the beneficiaries income tax free. The beneficiaries can transfer the cash value portion subject to income tax to their own individual retirement accounts, permitting the heirs to take advantage of the long-term deferral opportunity available to IRA rollovers by non-spouse beneficiaries. This enhances the value of the death benefit to the heirs and permits the blending of family insurance needs with the tax deferral opportunities normally available from a qualified plan. In some cases, if the qualified plan will continue after the participant’s death, the beneficiaries can leave the insurance proceeds in the plan. This permits the investment of those funds on a pre-tax basis for as long as the plan continues. The beneficiaries are required to take minimum required distributions each year, but the balance held in the plan can be invested as part of the plan assets.
Life insurance needs arise from both personal and business concerns, and the qualified plan can be used to satisfy the needs in both circumstances. Funds held in a profit-sharing plan can be used to purchase any type of life insurance, including survivorship insurance and insurance on individuals in whom the participant has an insurable interest, permitting planning flexibility to address both family and business needs.
For example, if the insurance is needed to provide benefits on the second death of the participant and spouse, survivorship insurance can be purchased. This would be the case if the estate is significant enough to result in estate tax liabilities, or funds are desired to assure a college education for grandchildren or to fund a trust, including a special needs trust, for a disabled child or grandchild. For these and similar second death concerns, second-to-die insurance is often the policy of choice.
If the insurance is needed on the participant’s death, perhaps as a result of a second marriage and conflicting concerns for spouse and children by a prior marriage, insurance on the participant can be purchased.
In some cases, the need is to equalize the inheritance of children not involved in a business with that of children who are involved. The business owner can acquire life insurance inside the plan payable to the children who are not involved in the business, avoiding the need to leave some interest in the business to inactive children. In other cases, the insurance provides additional security to a surviving spouse, again allowing the business to pass to the children active in the business without placing the spouse in a vulnerable position and dependent on the success of the children. The insurance can be used to avoid unnecessary conflicts between spouse and children.
Funds held in a participant’s account in a qualified plan can also be used to purchase life insurance to fund a buy-sell agreement. In that instance, each participant purchases insurance on the other business owners, and the insurance is paid to the participant’s account in the plan. With proper planning, the insurance proceeds other than the cash value can be distributed without tax to a surviving owner and used to purchase the interest.
A primary concern when insurance is purchased with funds in a qualified plan is the procedures involved to remove the policy from the plan in the appropriate circumstances. For example, if an insured participant terminates employment or retires, removing the policy from the plan is generally necessary. If the plan must terminate, the policy will also have to be removed.
A policy can be removed from a plan by either distribution or purchase. The policy can be distributed as part of the plan benefit any time the participant is entitled to distributions from the plan. The value of the policy at that time would be treated as a taxable distribution.
The policy may also be purchased from the plan. The law provides that policies can be purchased by the insured, a relative of the insured, or a trust created by the insured or for the benefit of the insured’s family. A purchase can be made at any time so long as the policy can no longer be retained in the plan. The Department of Labor has ruled that a policy purchased at the direction of the participant will be treated as one no longer able to be maintained in the plan if the participant directs that this should be the case.
There is, of course, a cost involved with the distribution or purchase of a policy from a plan. If the policy is distributed, the participant is subject to income tax on the value at that time. If the policy is purchased, the purchase price must be paid to the plan. Such a purchase, however, is mostly a cash flow concern, because the amount used to purchase the policy is paid to the plan and deposited to the participant’s account. In all cases, however, the availability of the insurance at significantly lower cost while the policy is in the plan and the portability of the policy at the time of termination or retirement generally offsets the cost of distributing or acquiring the policy should the need arise to do so.
While the use of qualified plan funds to purchase life insurance is not a technique for everyone, such a purchase will often permit the satisfaction of a life insurance need at a substantially reduced cost, and with the same or more flexibility as would an individual purchase of a policy. Because in a profit-sharing plan the purchase can be on the life of the participant, the joint lives of the participant and another person, or anyone in whom the participant has an insurance interest, insurance can be purchased in a qualified plan to satisfy virtually any life insurance need.
In addition, qualified plan funds are generally subject to income tax, which reduces their value to the heirs. A life insurance policy will in virtually all instances return more value when the participant dies than the investment of the funds in any other manner. The additional income tax-free amount payable as a death benefit because the funds were used to pay life insurance premiums permits more dollars to be available to the heirs.
Qualified plan funds should be recognized as another source of premium dollars, and one with a great deal more relevance in a difficult economic environment. Such funds are generally not viewed as readily available for day-to-day expenses, and their inaccessibility for those expenses makes the funds ideal for payment of life insurance premiums when personal funds are needed for other immediate purposes. Even if funds might otherwise be available for insurance premiums, the tax leverage dictates consideration of the qualified plan funds for this purpose given the extra value for the heirs.
All planning requires a degree of care when implemented, and the purchase of life insurance in a qualified plan is no exception. But with proper planning the purchase can provide meaningful benefits to the participant and beneficiaries.