Life insurance can often be purchased under favorable terms and conditions through a qualified pension or profit-sharing plan. The insurance is purchased and owned by the plan, using employer contributions to the plan as a source of funds. Understanding the disadvantages helps to make better financial and policy decisions.
- The plan participant must be annually taxed on the Reportable Economic Benefit (REB) cost of the net amount at portion of the death benefit. This cost becomes more expensive as the insured ages. However, if the policy is distributed to the participant, the cumulative REB constitutes basis and that amount is deducted from the FMV to determine the amount of taxable income. In addition, upon the death of the insured participant, the taxable cash value portion of the policy that is paid out as a retirement benefit can be reduced by the cumulative REB cost.
- Some life insurance policies may provide a rate of return on their cash values which, as compared with alternative plan investments, may be relatively low. However, rates of return should be compared on investments of similar risk.
- Policy expenses and commissions on life insurance products may be greater than for comparable investments.
- Upon the death of the insured, income is recognized by the beneficiary in an amount equal to the cash value portion of the policy immediately before the insured’s death. This taxable amount may be lowered by the sum of any Table 2001 costs reported by the employee (formerly P.S. 58 costs were used). But this should be compared with the receipt of the entire proceeds income tax free when the policy is purchased outside a qualified plan with after-tax dollars.
- Some authorities believe that since life insurance outside a qualified plan can definitely be kept from the insured’s estate while life insurance within a qualified plan from the insured’s estate is includible in the estate, it makes sense from an estate tax viewpoint to purchase life insurance outside a qualified plan (assuming the insured is healthy and insurable at standard rates). However, if estate inclusion is an issue, another solution is to purchase the insurance in the plan and then later have the insurance purchased from the plan for its FMV by the insured’s Irrevocable Life Insurance Trust (ILIT). Such a purchase would not be considered a prohibited transaction It would also avoid the three-year estate inclusion rule, which does not apply to any bona fide sale for an adequate and full consideration in money or money’s worth. Transfer for value may be an issue, but this can generally be avoided by making the ILIT a partner of the insured or making the ILIT an intentionally defective grantor trust with respect to the insured.
Reproduced with permission. Copyright The National Underwriter Co. Division of ALM