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Life insurance in qualified plans.

In addition to retirement benefits, pension and profit-sharing plans may provide life insurance coverage. Here is a brief explanation of the applicable rules, and who might want to take advantage of them.

Incidental death benefits

Pension and profit-sharing plans may provide for the payment of "incidental" death benefits (Regs. Sec. 1.401-1(b)(1)). Depending on the type of plan, the maximum amount of plan funds that can be used to purchase insurance ranges from 25% to 100%. (See Rev. Ruls. 61-164, 60-84, 60-83, 61-121, 68-31, 68-453 and 74-307.)

Tax treatment of life insurance coverage

The cost of life insurance coverage purchased by a qualified plan must be included in the employee's gross income if the proceeds are payable to the employee or a beneficiary of the employee (Regs. Sec. 1.72-16(b)). For this purpose, "cost" is not the premium payment; instead, cost is calculated using the P.S. 58 rates, which generally will be less than the actual premium (Rev. Rul. 55-747). If the insurer's rates for original issue one-year term insurance protection available to all standard risks are lower than the P.S. 58 rates (usually the case), those rates can be used instead (Rev. Ruls. 66-110 and 67-154).

Although the purchase of life insurance coverage appears to be a plan distribution, since it provides the plan participant with a current taxable benefit, the cost of coverage included in an employee's income is not considered a distribution for purposes of the 10% premature distributions tax (IRS Notice 89-25).

Tax treatment of life insurance proceeds

Life insurance proceeds in excess of a policy's cash surrender value are excluded from income under Sec. 101(a) (Sec. 72(m)(3)(C); Regs. Sec. 1.72-16(c)(2)(ii)). The cash surrender value (in excess of the investment in the contract) immediately before the insured's death is treated as a plan distribution includible in income except to the extent exempted under Sec. 101(b) (Sec. 72(m)(3)(C); Regs. Sec. 1.72-16(c)(2)(iii)).

Caution: Even though the regulations allow plans to provide insurance coverage for a participant's family members, the purchase of a cash value policy on a family member's life could result in a premature distribution if the family member dies before the participant reaches age 59 1/2. Choosing a second-to-die policy on the lives of the participant and a family member would avoid this potential problem.

The amount of policy proceeds in excess of the cash surrender value immediately before death is not subject to the Sec. 4980A excise tax (Temp. Regs. Sec. 54.4981A-1T, d-6). This may be a substantial benefit for those with large retirement plan balances.

Even without income and excise taxes, the government can profit handsomely from a large insurance policy if the policy is subject to estate tax. If an insurance policy is held directly by a retirement plan, the employee will have incidents of ownership in the policy (such as the right to change beneficiaries). Consequently, the policy proceeds will be includible in the participant's estate. There are two ways to avoid this problem: (1) distribute the policy to the insured or (2) transfer the policy to a properly structured subtrust.

If the plan distributes the policy to the participant before death, the participant can then transfer the policy to a life insurance trust or a family member. (Gift taxes may result.) This strategy generally is good only for those who entered into such an arrangement in the past and find that it is no longer useful. Unless the participant is over 59 1/2 or has only a term policy, the premature distribution tax will apply on distribution of the policy. Distribution of a cash value policy will result in income tax as well.

Although more complicated, the subtrust technique allows for continued life insurance in the plan while avoiding estate taxes on the policy proceeds. This technique requires a trust separate from the plan (a "subtrust") to hold the policy. The subtrust is structured so that the participant has no "incidents of ownership" in the policy. Consequently, the policy would not be includible in the participant's estate.

Plan distributions

Purchasing a life insurance policy (other than a term policy) with plan assets results in two distinct benefits: (1) current life insurance coverage and (2) an investment (the cash surrender value). The insurance coverage is treated as a taxable plan distribution. The cash surrender value, however, is retained in the plan. Consequently, participants may have problems with defined contribution plans when they take plan distributions.

First, participants may have difficulty taking required minimum distributions under Sec. 401(a)(9). For example, as a participant nears the end of his actuarial life expectancy, he may have no cash left in the plan--only the insurance's cash surrender value. Second, since individual retirement accounts (IRAs) cannot provide life insurance coverage, a life insurance policy cannot be rolled over to an IRA. Thus, if the individual is required to take a distribution, absent the ability to roll such amounts over into another qualified plan, the value of the policy will be currently taxed.

The easiest way to avoid these difficulties is to purchase only term insurance with a relatively low value before death, with plan assets. Alternatively, the trustee could cash in the policy to obtain the necessary cash. To avoid losing the insurance coverage, the trustee could borrow against the policy to pay distributions, or the trustee could distribute the policy outright to the participant. Without the ability to roll over the policy into an IRA, however, a participant under age 59Y2 who receives the policy outright could be forced to pay a premature distribution tax on the policy's cash surrender value. This could occur when the plan is terminated or when the employee separates from service.

Who needs it?

Clearly, purchasing life insurance with retirement plan assets is not appropriate for everyone. in fact, most people would choose not to put a tax-free investment in a tax-deferred vehicle. However, participants in defined benefit plans may increase their maximum allowable plan contribution by using plan assets to purchase life insurance, if the added death benefit does not reduce the plan-provided retirement benefits. To keep retirement benefits the same, additional plan contributions may be required to replace the funds spent on insurance. Defined contribution plan participants will not get this benefit.

Under some circumstances, insurance purchases will make sense in defined contribution plans too. For example, some plan participants may have insurance needs at a time when they are cash poor. In such cases, a retirement plan can be an excellent source of funds. Younger plan participants may want term life insurance coverage as a supplement to their vested retirement plan benefits in case of an early death. Once their retirement plans have sufficient value, they can discontinue the life insurance. older plan participants with large retirement plan balances may use plan assets rather than outside funds to buy needed insurance in order to reduce their exposure to the Sec. 4980A excise tax.
COPYRIGHT 1993 American Institute of CPA's
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Copyright 1993, Gale Group. All rights reserved. Gale Group is a Thomson Corporation Company.

Article Details
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Author:Henderson, Tracie K.
Publication:The Tax Adviser
Date:Jun 1, 1993
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