We all know that paying tax on income, and then investing what’s left in a taxable account, can put quite a drag on account growth. Investing after-tax money in a tax-deferred environment sounds better, all things equal. And investing pre-tax money in a tax-deferred account, such as a 401(k), IRA, etc., sounds even better.
However, many do not consider offsetting factors. For IRAs and 401(k)s to provide significant additional after-tax retirement income, many years of actual growth and compounding must occur, which is easier said than done. In addition, these accounts not only postpone the tax, they also postpone the tax calculation. With the prospect of rising tax rates, figuring the after-tax effect of various strategies is not easy.
But what if one could achieve “pre-tax in, tax-free out”? That would be the ultimate in tax planning, and it can be achieved when purchasing life insurance inside a qualified plan. It’s important to remember that a qualified plan is any sort of defined contribution or defined benefit plan, such as a 401(k), profit sharing, traditional defined benefit or cash balance plan. IRAs are not considered qualified; therefore, life insurance is not a permitted investment in IRAs.
The plan document must allow the purchase of life insurance on the lives of the plan participants. It can provide for coverage for all employees who don’t opt out, or it can allow employees to individually elect to have some of their plan money used for the life premium.
The policies are owned by the plan, and the death benefit is payable to the plan. They should be “unisex” policies designed for use in qualified plans. Insurance companies that specialize in this area have such policies available, but it’s important to keep in mind that not all insurance companies do.
Every year, the insured plan participant pays income tax on the dollar value of the actual insurance protection — approximately equal to the term insurance cost. This is commonly called the “PS58 cost.” The sum of all those costs down through the years is the participant’s “basis.” If he or she dies while a participant in the plan, his or her estate will pay income tax on the policy cash value minus the basis. (Business owners don’t subtract the basis.) In other words, the policy cash value is treated like any other plan investment. The death benefit in excess of the cash value is income-tax free.
The policy cannot stay in the plan after an employee separates from service. He or she can buy the policy or take it as a plan distribution. Obviously, if a business owner wants to keep the policy inside a qualified plan until his or her death (in order to get maximum tax advantage for the family), he or she will need to keep some kind of qualified plan in existence, even in retirement. This is generally not hard to do, though plan administration formalities must be followed.
How much of a participant’s plan money can be used as premium? The incidental death benefit limit states that up to 50% can be used as whole life premium, and up to 25% can be used as universal life (UL), variable universal life (VUL), or term premium. However, these limits can be exceeded with the use of “aged money.” In general terms, it is considered aged money if the money has been in the plan for two years, or if the participant has participated for five years. IRAs cannot buy life insurance, but money rolled from an IRA into a qualified plan can.
UL advantages
Rule changes for defined benefit plans in the past few years have affected what kind of life insurance is most suitable in defined benefits. Whole life used to work fine and in some cases still does, but now UL works better. Some insurance companies have special high-initial-cash-value unisex pension policies which appeal to business owners.
One advantage of UL over whole life is that the insured/participant has wide discretion about how much retirement plan money to put into the policy vs. into other investments. Managing the policy for minimum cash value potentially provides the greatest long-run tax advantages, but obviously, such a strategy needs to be managed to avoid policy lapse.
“Fully Insured” advantages
One special kind of defined benefit plan is called “Fully Insured,” formerly known as a 412(i) plan (it now falls under 412(e)(3)). In this plan, all forms of benefit are guaranteed by a single insurance company, whose annuity and life insurance contracts are exclusively used to fund the plan. Such a plan could be funded with annuities only, but generally, the addition of life insurance to the defined benefit plan increases the business’s deductible contribution.
In smaller businesses, where owners are older and employees are younger, various plan design techniques can be used legally to skew contributions and benefits more towards the owners. This can be of great advantage when a personal or business need exists for life insurance.
You will need to work with a third-party administrator (TPA) who not only knows the qualified life insurance rules, but who is also not averse to doing the extra calculations and who does not charge excessively for the work. Many independent TPAs view qualified life insurance as a nuisance, but insurance companies that have their own TPAs want your business. They also tend to be expert in the custom design of qualified plans and keep up with administrative rule changes over time.
The life policies are usually portable, so employees who leave the company can take their coverage with them. However, I have found that while employees usually are happy to have the extra death benefit when the employer pays for it, when faced with the prospect of paying for it themselves, they tend to drop it. It’s the business owners who seem to recognize the long-term value of the insurance. When you can show them how to deduct their premiums — legally — they really appreciate that.
Here is a comparison of buying life insurance either outside or inside a qualified plan:
We see that at mortality, the tax-free death benefit is about the same as the non-qualified policy’s. But our owner had to pay qualified premiums for only 10 years instead of 15 to achieve that result. Also, during the premium-paying period, the qualified cash values were outperforming the non-qualified cash values, even after tax, and could have been considered as a “bond substitute” in the investment mix.
Obviously there are tradeoffs, but any time you can show a successful business owner how to make a non-deductible expense tax deductible, you’ll have an audience — and maybe make a permanent life insurance sale, too.
Bill Magnusson, CLU, MBA, CFP, is a life member of MDRT and is an associate at Berkshire Advisor Resource in Greenwood Village, Colo. He has been in practice 13 years.