- Defined-contribution plans (profit-sharing plans are quite similar) establish the amount of the contributions, with the benefits fluctuating depending on the investment performance.
- Defined-benefit plans establish the amount of benefits, with the contributions fluctuating depending on investment performance.
- Up to 50% of pension contributions can be used to pay premiums for whole life insurance and up to 25% for universal life. These premiums, being part of the pension contribution, are fully tax-deductible. The equivalent term insurance costs are included in income and the insured pays personal income taxes on this amount. As an insured gets older, the amount of taxable income increases.
- If the insured dies while participating in the pension plan, the death benefits are income tax free, but the cash values are fully taxable, less the cumulative term insurance costs incurred. For example, if the death benefits are $500,000 and the net cash values are $200,000, then $300,000 is not subject to income taxes and $200,000 is taxable as a pension distribution.
- Life insurance proceeds are included in the insureds estate and subject to estate taxes if the insureds net worth is more than $1 million, with the taxes delayed if an unlimited marital deduction is used.
- If the assets in the pension plan are transferred to an IRA at retirement, which is very common, the life insurance policy must either be terminated or distributed to the insured. If it is distributed, its value (usually the cash value) is fully taxable.
A Life Settlement Update; and Life Insurance in Pension Plans
by Peter Katt
My May 2002 column was about life settlements, which is the selling of unneeded or no longer affordable life insurance policies [Does It Make Sense to Sell Your Life Insurance Policy?].
These sales only apply to insureds over 65 whose health since purchasing the policy has deteriorated more than just having gotten older. It is this deterioration in health that creates the mortality arbitrage necessary for life settlement firms to purchase a clients policy. (Life settlements should not be confused with viatical sales, which refer to the purchase of policies from terminally ill insureds regardless of their age.)
Whether the sale of a life insurance policy or its retention is a better option requires an analysis and then judgment by individual policyowners. However, if selling a policy is the decision, the following may be helpful.
Be aware that there are two types of life settlement firms. One type purchases policies for their own investment purposes. Another group purchases policies and repackages them to sell to investors. (Firms buying policies for their own account may securitize them and sell investment units to investors, but investors arent buying a particular policy or a portion of a particular policy.)
It is reasonable to believe that firms buying policies for their own accounts will be more prudent in pricing them. Conversely, firms who are essentially playing a middleman role have the potential incentive to be less prudent in pricing policies so they can expand their inventories of policies to package and sell to investors. Therefore, there is the potential that firms repackaging policies may pay higher amounts to buy policies.
Firms repackaging policies to sell to investors assure me that investors cannot identify insureds, but I am not convinced that a motivated investor couldnt obtain this information with some investigation. Unless specifically instructed by clients, I am staying clear of the life settlement firms that resell policies because Joseph Belths (editor and publisher of Insurance Forum) constant warning about mayhem to (specifically, the possible murder of) insureds isnt completely farfetched.
I have been somewhat surprised at the number of quality life settlement firms (all buying policies for their own accounts). I had been familiar with Coventry First (www.coventryfirst.com), a firm that has been very forthright and helpful. In addition, I have found Peachtree Life Settlements (www.lumpsum.com), Living Benefits Financial Services (www.livingbenefitsllc.com), Life Equity (www.lifeequity.net) and Stone Street Financial (www.stonestreetfinancial.com) to be professional to deal with.
If you want to sell an insurance policy, I recommend that you submit information to several or all of these firms because they do compete and it can improve the offer you can obtain.
If possible, avoid using an insurance agent because they earn up to 15% in commissions. If there is no commission, you can improve how much you receive by the amount not spent on the payment of commissions.
Life Insurance in Pensions
Having life insurance in your pension plan is permissible, and some insurance agents, attorneys and CPAs believe it is very astute tax planning.
Most uses of life insurance in pension plans are six-of-one-half-dozen-of-another, a few are abusive that will likely cause IRS scrutiny and at least one use is truly the grand slam of tax/life insurance planning. There are two basic types of pension plans:
Here is a summary of factors involved with life insurance being owned by a defined-contribution pension plan:
First of all, the investment yields will be lower within the life insurance policy because permanent life insurance expenses are very high. Reductions of 150 to 400 basis points in investment performance should be expected for a life insurance investment compared to a similar investment outside of life insurance—depending on how long the policy has until the insureds retirement. For example, Bob, a 42-year-old male with a $1 million life insurance policy with annual premiums of $10,000 inside his pension plan may have an asset value that is some $125,000 less by age 65 than if the $10,000 had been invested outside a life insurance policy.
Another potential problem is the exposing of death benefits to estate taxes because they are included in the insureds estate. However, this can be avoided with a policy that is owned outside the insureds estate. The third potential problem is prematurely paying taxes on the policys cash values if it is distributed to the insured at retirement because he wants to roll his pension assets into an IRA.
When all of these factors are considered, I believe most individuals will avoid having life insurance owned by their pension plans.
Not only should a full assessment be done for anyone contemplating the purchase of life insurance in a defined-contribution plan, but an assessment should be done for individuals with life insurance that is currently owned by a defined-contribution or profit-sharing plan. Assessing an existing policy is more complicated because full consideration must be given to the impact if the individual wants to remove the policy from his pension plan. Sometimes it will be best to purchase a new policy and then terminate the policy in the pension plan, and other times it will be best to withdraw and leave in the pension plan as much of the cash value as possible and then distribute the policy out. Among the considerations is the kind of policy (i.e., whole, universal or variable life) and whether any of the transactions will trigger penalty taxes.
Problems in Defined-Benefit Plans
Regarding potentially problematic plans, I have recently reviewed a number of what appear to be abusive defined-benefit plans that only use life insurance funding. These are 412(i) plans. Generally, 412(i) plans are legitimate defined-benefit retirement plans that use life insurance and annuity funding. But the potentially abusive plans claim extraordinarily higher tax-deductible contributions than legitimate plans and have grossly higher life insurance amounts. These possibly abusive 412(i) plans are designed for the participant insured to then purchase the life insurance policy after a short period, usually five years, for a substantially understated amount. This is what its promoters claim creates a huge tax break. The IRS has clearly signaled that they are looking for these plans and they may deny excessive contributions and tax them instead as dividends. The IRS may also impose sanctions such as plan disqualification, penalty taxes and interest. And as a statement of anger and frustration about abusive 412(i) plans, the IRS has even hinted at certain criminal penalties. If you want to read the gory details please go to www.peterkatt.com, Alerts, Tips and Information section, and see Vol. 5 No. 2. Embedded in this Alert is a redacted report to a client about an abusive 412(i) plan he had been pitched.
Where It Does Work
There is at least one situation in which having a defined-benefit pension plan own life insurance is maximum planning. As noted, the distinguishing feature of a defined-benefit pension plan is that the contributions are based on funding the retirement benefit specified by the plan. This is expressed by the amount of retirement benefit starting at a specified age.
When life insurance is owned by a defined-benefit plan, its illustrated cash value at retirement is part of the funding target. Referring back to our earlier example of 42-year-old Bob, with life insurance of $1 million, and a $10,000 premium in a defined-contribution plan, the illustrated cash values are around $300,000 at age 65. Lets assume Bob is instead installing a defined-benefit plan with a specified benefit of $75,000 a year starting at age 65. This will require a fund of $1 million, of which $300,000 will come from the life insurance cash values. The $10,000 premium generating an illustrated cash value of $300,000 assumes Bob is in good health.
Lets change this, and assume Bob is in poor health and just barely insurable. Because of a very large sub-standard rating, the premium needed to accumulate $300,000 at age 65 is $20,000 instead of $10,000. If this policy is owned by a defined-benefit plan the entire sub-standard premium of $10,000 is pure tax-deduction without any negative effects on Bobs benefits because a defined-benefit plans costs can go up to legitimately produce the specified benefits. This only works because the specified benefits define the costs, not the other way around. Therefore, Bob gets his very expensive life insurance paid for with entirely tax-deductible premiums without it affecting his benefits.
Peter Katt, CFP, LIC, is sole proprietor of Katt & Co., a fee-only life insurance advisor located in Kalamazoo, Michigan (269/372-3497; www.peterkatt.com). His book, The Life Insurance Fiasco: How to Avoid It, is available through the author.