life insurance in a qualified plan chapter 13 employee benefit & retirement planning copyright...

Copyright 2009, The National Underwriter Company 1

Life Insurance in a Qualified Plan

Chapter 13Employee Benefit & Retirement Planning

What is it?

Qualified plan purchases and owns life insurance on employee using deductible employer contributions to the plan to fund purchase




When is it indicated?

• large number of employees covered under qualified plan have unmet life insurance needs

• have gaps or limits on other company plans that provide death benefits

• want contribution option that would provide tax deduction when qualified plan is over funded or close to full funding limitation




When is it indicated?

• highly compensated plan participants face substantial estate taxes on death benefits

• life insurance could provide plan participants an additional option for investing their plan accounts

• employer wants secure funding vehicle for plan




Advantages

• favorable tax treatment as compared with individual life policies provided by employer outside qualified plan or personally owned life insurance

• safe investment• predictable plan costs




Advantages

• retirement benefits guaranteed by insurance company as well as employer

• death proceeds less policy cash values (pure insurance portion of policy) not subject to income tax

• may be able to structure insured plan death benefits to avoid estate tax at participant’s death




Advantages

• exemption of fully insured from minimum funding standards and actuarial certification requirements reduces administrative costs and reduces complexity of defined benefit plan

• some life insurance companies provide low cost installation and administrative services if plan uses their investment products, further reducing cost




Disadvantages

• relatively low rate of return• policy expenses and commissions may be greater

than for comparable investments




How is it used?Insurance Coverage

• should provide for all plan participants under nondiscriminatory formula that is related to either

– retirement benefit– plan contribution formula




How is it used?Insurance Coverage

• can condition coverage on medical exam IF this requirement does not discriminate in favor of highly compensated

• can minimize turnover costs with cash value insurance

– make waiting period for insurance longer than plan’s waiting period for entry

– use term insurance to cover interim




How is it used?How Much Insurance – The ‘Incidental’ Test

IRS: any non-retirement benefit in qualified plan is incidental as long as cost of benefit is < 25% of total plan cost

Difficult standard to apply




IRS has developed 2 practical tests

1. participant's death benefit must be no more than 100 times the expected monthly benefit

2. Aggregate premiums paid for participant’s insured death benefit are at all times less than these percentages of plan cost for that participant:

“ordinary life” insurance 50%

term insurance 25%

Universal life 25%




Life Insurance in Defined Benefit Plans

• adds to limit on deductible contribution • in contrast, in defined contribution plan, life insurance

costs must be part of contributions to each participant's account




Common ways life insurance is used in Defined Benefit Plans

• combination plan• envelope funding• fully insured plan




Combination Plan

• Retirement benefits funded with combination of– whole life policies– assets in separate trust fund (‘side fund’ or ‘conversion

fund’)

• Approach combines advantages of– insured death benefit– investment security of policy cash values– aggressive investment of side fund assets




Combination Plan

• Appropriate for smaller pension plans (< 25 employees)

• Death benefit for each employee usually determined by 100-to-1 test

• Annual plan cost = required insurance premiums + amount deposited in side fund that is determined on actuarial basis




Envelope Funding

• Insurance policies simply considered plan asset• Actuary determines total annual contributions to plan

to provide retirement and death benefits under plan• Employer makes contributions as determined by

actuary• Plan trustee purchases assets – including insurance

policies – to fund cost of retirement and death benefits




Envelope Funding

• Keep amount of insured death benefit within incidental limits by

– providing death benefit no more than 100 times each participant’s projected monthly pension

or– keeping the amount of insurance premiums within

appropriate percentage limits




Envelope Funding

• Requires lower initial contributions to plan than combination plan approach

• Long term costs depend on– actual investment results– policy dividends– benefit– administrative costs of the plan




Fully Insured Plans

Funded exclusively by life insurance or annuity contracts

Regaining popularity after pension investors lured away by high interest rates in 1970s and bull market of 1990s




Overfunding Problem forQualified Defined Benefit Plans

Tax deductible employer contributions– must meet actuarially determined minimum funding

amount– cannot exceed “full funding limitation”

Law limits interest rates that can be used in determining plan liabilities




A Solution – Fully Insured Plans[IRC Section 412(i) plans]

Exempt from minimum funding rules

Avoids overfunding problem




Plan is Fully Insured for Plan Year IF

• plan funded exclusively by purchase of individual insurance contracts

• contracts can be – individual or group– life insurance, annuity contracts or combination

• have level annual (or more frequent) premiums extending to retirement for each individual




Plan is Fully Insured for Plan Year IF

• plan benefits are equal to the contract benefits and guaranteed by licensed insurance company

• premiums paid without lapse or reinstated after lapse• no rights under the contracts subject to security

interest during plan year• no policy loans outstanding at any time during plan

year




Fully Insured Plans

• must be nondiscriminatory regarding– rights– benefits– features

• benefit formulas of plans satisfying safe harbor and specified uniformity requirements are considered nondiscriminatory in

– contributions– benefits




Fully Insured Plans: Other Advantages

• simplified ERISA reporting requirements• do not need certification by enrolled actuary• reduced cost and complexity of plan administration• exempt from requirement of quarterly pension

deposits but subject to Pension Benefit Guaranty (PBGC) coverage and annual premium requirements




Fully Insured Plans: How Does it Work?

• can be used with new or existing plan• employer can be corporation or unincorporated

business• typically uses group contract with individual accounts

for participants





• insurance company guarantees all benefits • premium based on guaranteed interest and annuity

rates; conservative estimates results in larger initial deposits than in typical uninsured plan





• use of excess earnings to reduce future premiums means funding level high at beginning, resulting in

– maximization of overall tax deduction– possibility of tax deduction for existing plan that has

reached full funding limitation with uninsured funding




Life Insurance in Defined Contribution Plans

• part of each participant’s account can be used to purchase insurance on the participant’s life

• insurance purchase can be– voluntary – provided automatically as plan benefit– provided at plan administrator’s option (on a

nondiscriminatory basis)





• insurance amount must be kept within incidental limits

• generally best to keep percentage contributions under full limits to maintain investment flexibility and employer ability to reduce contributions in lean years

• since IRS limit tests are computed in the aggregate, may be able to purchase a considerable amount of insurance in a later year





• in-service cash distributions allowed in profit sharing plans prior to termination of employment

• can be used without limit to purchase life insurance




Tax Implications

1. if amount of life insurance within incidental limits, employer plan contributions are tax deductible

2. economic value of pure insurance on participant’s life is taxed annually to participant at levels specified by the IRS; participant contributions are subtracted




Tax Implications

3. taxation of insured death benefit– pure insurance part is income tax free to plan beneficiary– total of all Table 2001 (formerly P.S. 58) costs paid by

participant recovered tax free– remaining distribution taxed as qualified plan distribution




Tax Implications

4. insurance in a plan usually provides tax advantages not available for individual life policies provided by employer outside qualified plan or personally owned life insurance

5. may be possible to exclude insured portion of qualified plan death benefits from decedent’s estate for federal estate tax purposes




Alternatives

1. personally owned life insurance

2. group-term life insurance

3. life insurance financing in a nonqualified deferred compensation plan

4. split-dollar life insurance




True or False?

1. Life insurance provides one of the safest available investments for a qualified plan.

2. To be nondiscriminatory, the same amount of life insurance must be given to each employee.

3. Life insurance is advantageous in a defined contribution plan because it adds to the limit on deductible contributions.




True or False?

4. In combination plans, retirement benefits are funded with whole life and assets in a separate trust fund.

5. Fully insured plans must be nondiscriminatory with respect to rights, benefits, and features.

6. Split dollar life insurance is an alternative to life insurance in a qualified plan.

7. Life insurance can be used in a Keogh plan.




Discussion Question

What are the considerations in determining whether fully insured funding is advisable from an economic, investment point of view?

life insurance in a qualified plan chapter 13 employee benefit & retirement planning copyright...

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