Do you ever wish you could pay your life insurance premium with pre-tax dollars while keeping your benefit tax free? I am here to remind you that it can be achieved when purchasing life insurance inside a Qualified Retirement Plan (QRP). A qualified retirement plan is a plan that meets requirements as defined in the internal revenue code and as a result, such a plan is also eligible to receive certain tax benefits. These plans must be for the exclusive benefit of employees or their beneficiaries. A qualified plan is any sort of defined contribution or defined benefit plan, such as 401-k, profit sharing, traditional defined benefit or cash balance plan. IRA’s are not considered “qualified”; therefore life insurance is not a permitted investment in IRA’s
The first step in implementing the strategy is to direct the QRP to purchase life insurance on the plan participant. If a plan is currently not available then an individual as a sole proprietor can establish his or her own profit sharing plan; to establish such a plan one must have earned income. Once a QRP is in place the assets can be invested in life insurance as long as the plan document authorizes the purchase and the death benefits are incidental to the plans principle purpose of providing retirement benefits.
The QRP pays premiums on the policy. Those payments are a taxable event to the plan participant; however the amount subject to tax is not the amount of premium but the pure cost of the death benefit. This is called the “P.S. 58 cost” and is the amount the participant is required to include in gross income because of the plan held life insurance. This represents the annual cost of pure insurance protection and is used as “basis” for any purpose of the owner’s real expense. An owner employee does not want to treat that cost as an investment in the contract. Purchasing life insurance through a QRP leverages the amount spent on premiums. The main reason for the P.S. 58 cost is to maintain the distinction between the cash surrender value and the total amount of premiums paid, so when the insured dies and the policy proceeds are paid to beneficiaries, the death benefit will not be subject to income tax.
As stated earlier, life insurance may not be purchased in a traditional IRA, but an IRA can be over-looked too because QRP assets can be increased with IRA funds. IRA distributions made after 2001 can be rolled into a QRP without being subject to the incidental benefit test. In theory, a taxpayer with an IRA, but who does not participate in a QRP, could still take advantage of this strategy by creating a business entity and establishing a QRP themselves.
The money available upon retirement of the insured depends upon which options chosen at that time for handling the funds. Those options could include distributing the policy to him or her directly; surrendering the policy and having the cash value remain in the QRP, or purchase the policy from QRP. If the insured elects to have the plan distribute the policy, the policy value would be income to the insured, and the insured could reduce the taxable amount by its basis. Meaning if the cash value is $500,000, the insured’s basis is $25,000, the insured will include $475,000 in income in first retirement year. The tax is unavoidable, which makes surrendering the policy and having the cash value remain in the QRP possibly more attractive because immediate tax on the distribution could be avoided by rolling the distributed funds to an IRA. If the insured needs or wants the life insurance, he or she may elect to purchase the policy from the QRP. The insured will have to come up with the value of the policy. However if the insured purchases the plan, that could be interpreted as a prohibited transaction if the insured is an owner of the business. Fortunately a prohibited transaction exemption can be made available to the insured with the proper supporting documents.
To avoid any inclusion of the policy death proceeds in the insured’s estate it is necessary for the insured to pay tax on his/ her P.S. 58 cost and also have the beneficiary be a third party, such as using an irrevocable life insurance trust as the policy owner. If this is not done at the inception of the policy, it can be transferred at purchase or distribution, but there is a three year look back period that will be in effect. The insured’s estate should never be a beneficiary of the policy because the estate tax will inevitably come into play. In all cases the death benefit in excess of cash value is income tax free, but the amount attributable to the cash value minus basis in the policy is taxable income to the plan or beneficiary.
QRP funds should be recognized as another source of premium dollars, especially in today’s difficult economic environment. QRP’s are generally not viewed as available for day to day business expenses, and because of this inaccessibility for those expenses, QRP’s are a valuable asset for pre-tax payment of life insurance premiums.
The medical profession is being swamped with restrictions piled on top of restrictions. Hours spent at the hospital seeing patients or doing procedures are on the rise, but the paycheck may not be. The tax leverage dictates one to consider using a QRP as a tool for today’s dollars as well as the extra value it could provide heirs. All retirement and estate planning requires a great deal of care when implementing, and purchasing life insurance in a QRP is no different. Proper planning can provide meaningful benefits today as well as in the future.
Calvin R. Rasey is president of Physicians Financial Services II, LLC. He can be reached at (502) 893-7001.
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