Qualified Plans

ERISA-governed, tax-favored retirement plans:

Characteristics:
- Tax-deductible contributions: Employer deducts contributions
- Tax-deferred growth: Earnings not taxed until distributed
- ERISA rules: Subject to Employee Retirement Income Security Act
- Non-discrimination: Must cover broad employee base
- Contribution limits: Annual IRS limits
- Required distributions: RMDs starting age 73

Types:
1. Defined benefit plans (pensions)
2. Defined contribution plans (401(k), profit-sharing, money purchase)
3. 403(b) plans (tax-sheltered annuities for nonprofits)
4. 457 plans (deferred compensation for government/nonprofit)

Individual Retirement Accounts (IRAs)

Personal retirement savings:
- Traditional IRA: Tax-deductible contributions, taxable distributions
- Roth IRA: After-tax contributions, tax-free distributions
- SEP-IRA: Simplified Employee Pension (employer contributions)
- SIMPLE IRA: Savings Incentive Match Plan (small employer)

Non-Qualified Plans

Not subject to ERISA:
- Deferred compensation: Promise to pay in future
- Executive benefits: Selective, for key employees
- No current deduction: Employer deducts when paid
- Flexible: Not bound by qualified plan rules

General Rules

Life insurance is permitted in some qualified plans:

Allowed in:
- ✓ Defined benefit plans (pensions)
- ✓ Profit-sharing plans
- ✓ 401(k) plans
- ✓ Money purchase pension plans

Not allowed in:
- ✗ IRAs (traditional or Roth)
- ✗ SEP-IRAs
- ✗ SIMPLE IRAs

The "Incidental Benefit" Rule

Life insurance must be incidental to retirement savings:

Cannot be primary purpose:
- Primary purpose: Retirement income
- Life insurance: Incidental death benefit protection
- Limits apply: Strict percentage limits

The 50/25% Test (Premium Limitation)

Limits on life insurance premiums in qualified plans:

Whole Life Insurance

50% Test:

Life insurance premiums ≤ 50% of total contributions

Example:

Total contributions to participant account: $100,000
Maximum for whole life premiums: $50,000 (50%)
Remaining for retirement investments: $50,000

Term Life Insurance

25% Test:

Term insurance premiums ≤ 25% of total contributions

Example:

Total contributions: $100,000
Maximum for term premiums: $25,000 (25%)
Remaining for retirement: $75,000

Universal Life / Variable Life

Treated as whole life (50% test)

Example - Combined:

Annual contribution: $20,000
Whole life premium: $10,000 (exactly 50%)
Invested in mutual funds: $10,000

Total: $20,000
Meets 50% test: Yes

The 100-to-1 Ratio Test

Alternative test for death benefits:

Death benefit cannot exceed:

Death Benefit ≤ 100 × Projected Monthly Retirement Benefit

Example:

Projected monthly retirement benefit: $3,000
Maximum death benefit: $3,000 × 100 = $300,000

If death benefit > $300,000: Violates rule

Taxation of Life Insurance in Qualified Plans

PS-58 Costs (Table 2001 Costs)

Annual taxable income to participant:

Imputed income:
- Economic benefit: Value of pure insurance protection
- Table 2001 rates: IRS table (formerly PS-58)
- Taxable annually: Reported as income each year
- Only term portion: Cost of pure protection, not cash value

Formula:

Annual Taxable Amount = (Death Benefit - Cash Value) × Table 2001 Rate

Example:

Participant: Age 45
Death benefit: $500,000
Cash value: $50,000
Table 2001 rate (age 45): $1.53 per $1,000

Net amount at risk: $500,000 - $50,000 = $450,000
Annual PS-58 cost: ($450,000 ÷ $1,000) × $1.53 = $688.50

Participant reports: $688.50 as taxable income (annually)
Pays income tax on: $688.50

Why PS-58 Costs Are Taxable

Economic benefit doctrine:
- Current benefit: Participant receiving death benefit protection now
- Not deferred: Protection is current, not deferred to retirement
- Must recognize: IRS requires annual income recognition

Distribution of Life Insurance at Retirement

Options when participant retires or terminates:

Option 1: Cash Out Policy

• Surrender: Cash out cash value
• Roll to IRA: Roll cash value into IRA
• Lose coverage: No more life insurance

Option 2: Distribute Policy to Participant

• Receive policy: Take ownership of policy
• Taxable event: Taxed on cash value minus PS-58 costs paid
• Keep coverage: Continue life insurance

Taxable amount formula:

Taxable = Cash Value - Cumulative PS-58 Costs Already Paid

Example:

Cash value at distribution: $80,000
Cumulative PS-58 costs paid over years: $15,000

Taxable income: $80,000 - $15,000 = $65,000
Participant pays tax on: $65,000

Option 3: Convert to Annuity

• Use cash value: Purchase immediate annuity
• Retirement income: Provides monthly payments
• Lose insurance: Death benefit gone

Death Benefit Taxation

If participant dies before retirement:

Amounts paid to beneficiary:
- Account value: Taxable as ordinary income (qualified plan distribution)
- Life insurance proceeds: Income tax-free (IRC §101(a))

Example:

Death occurs:
Account value (investments): $200,000
Life insurance death benefit: $500,000
Total to beneficiary: $700,000

Tax treatment:
- Account value: $200,000 (taxable as ordinary income)
- Insurance proceeds: $500,000 (income tax-free)

Beneficiary owes tax on: $200,000 only
Receives tax-free: $500,000

Prohibition on Life Insurance

IRC §408 - Life insurance not allowed:

Cannot hold in IRAs:
- ✗ Traditional IRA
- ✗ Roth IRA
- ✗ SEP-IRA
- ✗ SIMPLE IRA

Reason: IRAs designed exclusively for retirement savings, not life insurance

Permitted:
- ✓ Annuity contracts (provide retirement income)
- ✓ Stocks, bonds, mutual funds
- ✓ Real estate (self-directed IRA)

Annuities in IRAs

Allowed:
- Annuity contracts: Provide life-contingent income
- Not life insurance: Focus on retirement income, not death benefit
- Tax-deferred: Grow tax-deferred in IRA

Types:
- Fixed annuities
- Variable annuities
- Indexed annuities
- Immediate annuities (at retirement)

Permitted but uncommon:

Structure:
- After-tax contributions: Typically funded with after-tax employee contributions
- Separate account: Life insurance in separate sub-account
- Participant choice: Optional, not mandatory
- 50/25% test applies: Must meet premium limitations

Example:

401(k) participant:
Pre-tax deferrals: $15,000 (goes to mutual funds)
After-tax contributions: $10,000 (funds life insurance)

Whole life premium: $10,000
Total after-tax contributions: $10,000

Meets test: Yes ($10,000 is ≤ 50% of total contributions)

Pension plans funded entirely with insurance:

Characteristics:
- 100% insurance/annuities: All assets in insurance contracts
- Guaranteed benefits: Insurance company guarantees benefits
- Level premiums: Fixed annual premiums
- Predictable: No investment risk
- Higher contributions: Typically higher than other pension plans

Used for:
- Small business owners
- Professional practices
- Older owners (catch-up)

Example:

Small business: 3 partners, age 55
Want: Guaranteed pension benefits
Fund with: Life insurance and annuities

Annual contributions: $150,000
Guaranteed retirement benefit: $5,000/month at age 65
Death benefit: $1 million per partner

Using Life Insurance to Fund

Informally funded:

Structure:
- Employer promise: Agreement to pay benefits in future
- Corporate-owned life insurance (COLI): Employer owns policy on executive
- Employer = owner and beneficiary: Controls policy
- Not plan asset: Executive has no rights to policy
- Helps fund: Provides cash to meet future obligation

Example:

Executive age: 45
Deferred comp agreement: $100,000/year for 15 years at retirement
Present value: ~$800,000

Employer buys COLI:
Insured: Executive
Owner: Corporation
Beneficiary: Corporation
Face amount: $2 million
Premium: $30,000/year

At retirement:
Cash value: ~$600,000
Employer uses: To help fund deferred comp payments

Tax Treatment

Employer:
- No deduction: Cannot deduct COLI premiums
- Deduct payments: Deduct deferred comp when paid to executive
- Death benefit: Income tax-free to employer

Executive:
- No current tax: Not taxed until receives payments
- Ordinary income: Taxed when receives deferred comp payments
- Forfeiture risk: If employer insolvent, may lose benefit

Life insurance instead of joint-survivor pension:

The Problem

Pension payout options:

Single life annuity:

Retiree only: $4,000/month
At death: Payments stop
Spouse: Gets nothing

Joint and 50% survivor:

Retiree: $3,200/month (20% reduction)
After retiree dies: Spouse gets $1,600/month (50%)

Cost of survivor benefit:

Reduction: $800/month ($4,000 - $3,200)
Annual cost: $9,600/year
Lifetime cost: $9,600 × 20 years = $192,000

The Strategy

Pension max approach:

1. Take single life: Choose higher single life payout ($4,000/month)
2. Buy life insurance: Use savings to buy policy on retiree
3. If retiree dies first: Spouse gets life insurance proceeds
4. If spouse dies first: Cancel insurance, keep higher pension

Example:

Choose: Single life at $4,000/month
Savings: $800/month vs. joint option

Use savings to buy:
Whole life insurance: $500,000
Premium: $800/month

If retiree dies:
Spouse receives: $500,000 (tax-free)
Invested at 4%: Generates $20,000/year ($1,667/month)
Compare to: $1,600/month joint option

Advantage: Slightly higher income + full principal ($500K)

Considerations

Advantages:
- Higher income: Get higher single life payment
- Flexibility: Can adjust insurance as needs change
- Lump sum: Spouse gets lump sum at death
- Upside: If spouse dies first, keep higher pension

Risks:
- Insurability: Must qualify for life insurance
- Premium increases: If term insurance, premiums may rise
- Policy management: Must maintain policy
- Investment risk: Proceeds must be managed

Starting age 73:

Life insurance cash value:
- In qualified plan: Subject to RMDs
- Must distribute: Take cash or distribute policy
- Taxable: Distributions taxable as ordinary income

• Life insurance prohibited in IRAs: Cannot hold life insurance in any IRA
• Incidental benefit rule: Life insurance must be incidental to retirement purpose
• 50% test: Whole life premiums ≤ 50% of total contributions
• 25% test: Term insurance premiums ≤ 25% of contributions
• PS-58 costs: Annual taxable income on economic benefit of life insurance
• Table 2001: IRS table for calculating PS-58 costs (current term rates)
• Net amount at risk: Death benefit minus cash value
• Distribution taxation: Cash value minus cumulative PS-58 costs
• Death benefit split: Insurance proceeds tax-free; account value taxable
• Qualified plan death benefit: Insurance portion tax-free under IRC §101(a)
• 100-to-1 test: Death benefit ≤ 100 × monthly retirement benefit
• Annuities in IRAs: Allowed (provide retirement income)
• 412(i) plans: Fully insured pension plans using life insurance
• COLI: Corporate-owned life insurance for deferred compensation
• Pension maximization: Take single life pension, buy life insurance with savings
• Non-qualified deferred comp: Employer owns COLI, executive has promise to pay