Use Your Retirement Plan to Buy Life Insurance with Pretax Dollars

Seymour Goldberg, Esq., CPA - Goldberg & Goldberg

 

For many people, life insurance remains desirable as they go through their 50s, 60s, and later years. There may be no alternative but to pay higher premiums because of your age.

But you can cut the cost of those premiums. One way: Pay for life insurance with pretax rather than after-tax dollars.

Say you're now paying $10,000 per year in life insurance premiums. Assuming a 40% effective tax rate, you have to earn more than $16,000 to net the $10,000 to pay the premiums.

If you can buy that insurance inside a tax-deferred retirement plan, only $10,000 is needed.

not prohibited

How can you pay for life insurance with pretax dollars? Move the policy into your company's tax-deferred retirement plan.

Caution: Ordinarily, "self-dealing" is prohibited by ERISA, the federal law covering the retirement plans. As plan sponsor, you can't enter into transactions with the plan. That would be self-dealing.

But several exemptions apply. The US Department of Labor has issued Prohibited Transaction Exemption (PTE) 92-5, which allows for transfers of life insurance policies and annuity contracts to a tax-deferred retirement plan, under certain circumstances.

In a recent Advisory Opinion (2002-12A), the Labor Department details how this exemption can apply.

case history

The Advisory Opinion came in response to a query from a principal at a small professional practice. This professional had recently purchased a whole life policy, which was not expected to have any cash surrender value for three years. His partner had a term life insurance policy.

Legal question: These two professional asked the Labor Department about transferring their policies to the firm's profit-sharing plan.

Answer: Green light. The Labor Department said that transferring the policies into the profit-sharing plan was not a prohibited transaction.

Required: The plan must acquire the insurance policies for the lesser of the cash surrender value or the participant's account balance. (The rules are slightly different if the company has a defined-benefit plan.)

Example: John Jones owns a life insurance policy with cash surrender value of $10,000. His profit-sharing account is $25,000. If he wants to transfer his policy to the profit-sharing plan, the plan will have to pay him a lesser amount - $10,000.

If his insurance policy had a $30,000 cash value, the transfer would have to be $25,000-if John is willing to transfer the policy for that account.

point zero

In the scenario above, where the person seeking the Advisory Opinion had a whole life policy with no cash surrender value, the transfer had to be for no consideration (money). The policy could simply be transferred to the firm's profit-sharing plan.

Because a term life insurance policy never has any cash value, such a policy can also be transferred to an employer-sponsored retirement plan for no consideration.

Other requirements: PTE 92-5 lists other conditions that must be met for such a transfer to be approved...

1. No lien or mortgage can apply to the transferred policy. You can't transfer a policy with outstanding policy loans.

2. The transfer must not conflict with the plan documents. In practice, the plan documents must permit the purchase of life insurance.

planning implications

Advisory Opinion 2002-12A opens up some interesting tax-planning opportunities...

Cash from your company. If you have an insurance policy with cash surrender value, you can sell it to your company's retirement plan, often the amount of cash surrender value. This will allow you to pull tax-free cash from your firm.

Free transfers. Term policies with no cash surrender value can be transferred at no cost, provided the plan documents authorize such transfers.

New policies. Alternatively, you can simply use plan money to buy a new insurance policy.

In all of these scenarios, ongoing premiums may be made with dollars held inside the plan. Thus, you'll be buying insurance with pretax rather than after-tax dollars.

Trap: You can't buy life insurance with money held in an IRA. But the 2001 tax act makes it easier to bring IRA dollars to your company's plan, if you wish to use those funds to buy life insurance. This law permits all IRA distributions made after 2001 to be rolled into an earmarked account within the qualified plan - provided the qualified plan offers that option.

In addition, the plan document can provide that the earmarked account offer an option that permits the account to purchase life insurance.

Limit: Nondeductible contributions can't be rolled over.

Procedure 1: If you're rolling IRA funds into a qualified plan that has the options described earlier, you should roll them into a designated profit-sharing account that provides for the purchase of life insurance. By limiting insurance purchases from a specified account, you won't be bothered with the life insurance concerns of the other plan participants who do not exercise these options.

Procedure 2: What if you have an IRA fund but do not currently participate in a qualified plan? You can take advantage of this strategy by creating your own business, such as a consulting firm, and setting up a self-employed retirement plan that provides for the purchase of life insurance within a rollover account. Then you can move an insurance policy into the new plan.

paying the price

If your qualified plan pays ongoing premiums on your insurance policy, those payments will be a taxable event to you, as the plan participant enjoying the insurance protection.

Loophole: The amount subject to tax is not the amount of the premium paid. Instead, only the cost of pure insurance protection (the cost of term insurance) must be recognized as taxable income.

You can get a value for the term insurance protection from the IRS Table PS 58 (in Revenue Ruling 55747, 1955-2 CB 228). Alternately, you can use the insurance company's term rate, which is generally substantially lower - and would thus generate even less taxable income.

Either way, you'll probably pay only a modest amount of tax, compared with the insurance protection you'd get. Typically, you'll save thousands of dollars in tax each year.

Example: As mentioned, you might have to earn more than $16,000 and pay over $6,000 in tax to make a $10,000 premium payment outside of your retirement plan. If you're tapping your IRA to pay the premiums, the same would be true.

On the other hand, if the premium is paid by a qualified plan, and you pay tax on the imputed income, you might pay less than $3,000 in tax.

Even if you are in poor health and have to pay more for life insurance, you can use the standard table or standard rate for calculating imputed income. Thus, the tax savings will be even greater for those who are "rated" by insurance companies.

Record Keeping: Over the years, be sure to keep track of all the tax on this imputed income. At some point you may want to transfer the policy out of the plan to yourself. The amount subject to tax will be the cash surrender value of the policy as of that date.

However, the amount subject to tax can be reduced by the sum of the annual amounts of imputed income you have reported.

Reprinted with permission of Tax Hotline and Seymour Goldberg, Esq., CPA.