Inclusion of Life Insurance in Retirement Plans

At one time, Code section 2039(c) provided an unlimited exclusion for the amount distributed at a participant’s death from a qualified retirement plan to the extent attributable to employer contributions. That exclusion has been eliminated.

Subject to certain transition (grandfathering) rules, a decedent’s executor must include in the gross estate the value of any payment “receivable by any beneficiary by reason of surviving the decedent under any form of contract or agreement…(other than as insurance under policies on the life of the decedent),” if certain other conditions are met. So section 2039 will not cause the inclusion of the proceeds of a life insurance policy on a plan participant’s life. Does this mean the proceeds are estate tax free? The answer is “yes,” only if inclusion is not warranted under any other IRC section.

The Subtrust Concept

Some authorities have suggested that it is still possible to avoid federal estate taxation on life insurance proceeds paid as part of a distribution from a qualified retirement plan through a subtrust concept. One configuration of the technique works like this:

  1. The insured employee makes an irrevocable beneficiary designation that divests him of the right to change the beneficiary of plan proceeds.
  2. The qualified plan is amended to provide that the policy will not be distributed to the insured at retirement. This amendment is made to eliminate an IRS argument that the insured retained a reversionary interest in the policy.
  3. The plan is amended to give the insured a right to purchase the policy for its full value at retirement.
  4. To insulate an insured who is also a trustee of the plan from an incidents of ownership attack by the IRS, a special trust (subtrust) is created. Policies on the life of the insured-trustee are placed into the subtrust. The insured is given no control over the subtrust and cannot remove its independent trustee.

Will this subtrust concept work? The answer appears to be a resounding NO! In an unpublished Technical Advice Memorandum, the IRS has indicated that a life insurance subtrust may disqualify the pension plan. Though this TAM was not published, the taxpayer to whom it was issued sent a copy of it to Steve Leimberg who published it in his Employee Benefits and Retirement Planning Email Newsletter – Archive Message #385 (September 19, 2006).

Alternative to the Subtrust Concept

It is possible and sometimes desirable to remove life insurance from a qualified plan. Advantages of life insurance outside of a qualified plan include:

  1. the ability to invest in more assets producing otherwise currently taxable income and have the income on such assets grow income tax free;
  2. the ability to exclude life insurance purchased outside the plan from federal estate taxes and be assured that, if arranged properly, exclusion is a very high probability if not a certainty.

The easiest way to remove life insurance from a qualified plan is for the trustee to allow the policy to lapse and for new insurance to be purchased outside the plan (preferably by adult beneficiaries or a trust for the intended recipient of the proceeds). A sale by the retirement plan of the policy to the insured is another possibility. This is a more appealing choice where the insured is in ill health, the policy in question is beyond the incontestable period, or, for whatever other reason, the client does not want the original policy to lapse.

A sale to the insured or to the policy’s beneficiary is permissible under an exception to the prohibited transaction rules. In most cases, the preferred course of action is to have the insured (or an intentionally defective grantor trust created by the insured) purchase the policy to nullify the danger under the transfer for value rule. It is extremely important to document evidence that:

the contract would have been surrendered by the plan even if the sale had not taken place; and

the plan was placed financially in the same position it would have been in had it surrendered the contract and made a distribution of the amount the plan owed to the insured participant.

There are disadvantages to the sale to the insured technique. First, the insured does not receive credit for the income tax paid on the costs of life insurance protection. In other words, the plan participant cannot count as part of his basis the taxes paid for the term insurance protection he received year after year.

A second possible disadvantage is that the purchase by the insured does not solve the estate tax inclusion problem. That can only be accomplished if the insured then divests himself of all incidents of ownership and lives for more than three years after the transfer.

A third potential problem lies with valuation issues; if the insured is terminally ill or in exceptionally poor health, the amount necessary to purchase the policy may be significantly more than the greater of the Interpolated Terminal Reserve (ITR) or Premiums plus Earnings less Reasonable Charges (PERC) value that the IRS indicates must be used as the fair market value when life insurance is distributed or sold by a qualified plan.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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