By Kevin P. Nicholson
Many business owners worry about achieving a comfortable retirement after all the hard work and investment they’ve put into their business. But as the retirement gap for successful business owners continues to widen, the need for significant tax-deductions and retirement benefits have not diminished. This often compels owners to search for opportunities to lower their current tax liability, perhaps at the expense of their retirement plans. Business owners seeking answers to a difficult retirement dilemma may want to consider Internal Revenue Code (IRC) Section 412(e)(3) plans.
A Section 412(e)(3) plan is a type of defined benefit pension plan, and as such pays benefits to participants based on a plan formula, participant’s compensation, age, and length of service. As with other defined benefit plans, a 412(e)(3) is funded solely by the sponsoring employer. But while other defined benefit plans can be funded with a variety of investment options, these plans are funded exclusively with life insurance and annuity contracts, and are often referred to as fully insured defined benefit plans.
These plans are most appealing in situations where a business has older, highly compensated owners and few nonowner employees. When an employer has few nonowner employees, most of the current contributions will generally be used to fund the benefits for older, highly compensated owners, thereby driving larger deductions than those available with other pension and profit-sharing plans.
A 412(e)(3) plan allows a business owner to obtain benefits that only come with the ownership of life insurance in a qualified plan. Few retirement vehicles offer the self-completing nature of life insurance. An unexpected death can leave those left behind wondering where retirement funding is coming from. A fully insured plan ensures that the benefits that had been planned for retirement will be there for plan beneficiaries in the event of premature death, without the employer having to come up with additional funds.
Life Insurance in Qualified Plans
Life insurance inside qualified plans have been around a while, so there are rules that govern how life insurance can be used. Plan participants may be offered life insurance as a plan benefit as long as it is offered to all plan participants under a nondiscriminatory formula related to the retirement benefit or plan contribution formula. Because the primary purpose behind a qualified pension plan is to provide retirement benefits, life insurance must provide only an “incidental” death benefit to the plan. The IRS has tests for determining if life insurance is incidental in a qualified plan.
The economic benefit of pure life insurance coverage on a participant’s life is taxed annually to the participant at levels specified by the IRS. Generally, the value is taxed at the lower of the IRS Table 2001 costs or the life insurance company’s actual term rates for standard risks.
Additionally, at retirement, a decision must be made regarding the disposition of the life insurance contract. In many cases, the policy may be surrendered and rolled over into an individual retirement account (IRA), but there are several other options. The insured may desire to acquire the policy for personal planning purposes. This may take on a special importance should the plan participant no longer be insurable.
Keep in mind, noninsured qualified plan benefits paid to the plan beneficiary named by the decedent are fully taxable as “income in the respect of a decedent.” However, the benefits paid to the beneficiary of a 412(e)(3) plan holding life insurance are often income-tax free. The pure insurance element of the death benefit (the death benefit less any cash value) is income tax free to a participant’s beneficiary. In addition, the total of all Table 2001 costs paid by the participant can be recovered tax free from the plan death benefit (if it is paid from the same insurance contracts that gave rise to the costs). The remainder of the distribution is taxed as a qualified plan distribution.
Life Insurance Valuation
When an insurance policy is transferred to the participant as a plan distribution, like any other distribution of property, its value is taxable as ordinary income. The amount that must be included in income by the distributee is the fair market value of the property. Regulations provide that “policy cash value” and “all other rights under such contract are … included in determining the fair market value of the contract.”
As to the actual determination of the fair market value of the contract, the rules were revised in 2005. Under the 2005 guidance, the fair market value of an insurance contract may be determined as the greater of two measures: the “adjusted interpolated terminal reserve” (ITR) or the “adjusted PERC amount” (premiums, earnings, and reasonable charges). The PERC amount is the aggregate of the premiums paid, plus dividends, plus certain other earnings, minus reasonable charges and distributions.
In essence, Section 412(e)(3) plans afford an owner the ability to plan in way that goes beyond the benefit of a current tax deduction and may provide a solution to a difficult retirement dilemma.
Kevin P. Nicholson is cofounder of Walsh and Nicholson Financial Group in Wayne, Pa. He can be reached at firstname.lastname@example.org.
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