For small business owners, offering qualified plans is expensive and, combined with the contribution limits and discrimination testing, makes these plans increasingly less useful. An effective strategy to maximize the value of a qualified plan is to use the plan to tax-efficiently purchase a life insurance policy which can used as a source of future income or to provide liquidity for heirs.
A Split-Funded Defined Benefit Plan is a type of qualified retirement plan that provides guaranteed retirement income and the ability to use qualified money to purchase life insurance. The name comes from the ‘split’ in using the balance in the plan to purchase both cash value life insurance and other investments. The ultimate goal of this strategy is to transfer a policy purchased inside the plan to the participant’s trust or other arrangement to keep the income tax-free death benefit of the policy out of the participant’s estate.
Here’s an example of how a Split-Funded Defined Benefit Plan works:
Julie is a 53-year-old with a profitable accounting practice and an annual salary of $250,000. Julie wants to save more so she can meet her goal of retiring at age 65. Ideally, she wants a qualified plan that will allow her to make significant contributions toward her own retirement and provide tax deductions. In addition to making large contribution in order to “catch up” with her retirement plan, Julie wants a plan which gives her the ability to:
Provide a source of guaranteed retirement income
Protect her retirement assets from creditors
Participate in the growth of the stock market
Use pre-tax dollars to cover personal life insurance needs
Care for her family in the event of her premature death
Julie establishes a Split-Funded Defined Benefit Plan and makes annual tax-deductible contributions of $100,000. From this amount, the plan purchases a cash value whole life insurance contract costing $40,000 a year in premiums for 10 years. The initial death benefit is $750,000 and the beneficiary of the policy is the qualified plan. The remaining $60,000 of Julie’s annual plan contribution is invested in a diversified portfolio.
At retirement, Julie arranges for an irrevocable trust she established to purchase the policy from the plant for its fair market value. The cash value in the policy must be taken as a taxable distribution and a mandatory 20% federal income withholding applies, so a portion of the plan would have to be redeemed to cover this tax. After the transfer, the trust will continue to enjoy the tax-deferred build-up of cash value outside of both the qualified plan and Julie’s estate. The trust can access the policy’s cash value for tax-free loans to distribute to beneficiaries or to loan to Julie and the policy’s death benefit can be used in Julie’s estate plan.
There are a number of rules which need to be followed to successfully implement a Split-Funded Defined Benefit Plan. Proper plan documentation is critical to the plan’s ownership of life insurance. Depending on the plan provisions, most types of policies can be purchased in the qualified plan – term, whole life, universal life or variable universal life. It is critical that a Third-Party Administrator (TPA) who is familiar with life insurance as a component of qualified plans is selected to make sure the documentation, implementation and administration is handled correctly.
Also, the IRS has established guidelines which dictate how much life insurance can be purchased in a qualified plan, ensuring that the plan does not stray from its primary purpose of providing retirement income.
Allowing for life insurance to be purchased within a qualified retirement plan may be valuable in certain circumstances. Prospective participants are encouraged to seek professional assistance in navigating the number rules and procedures which, if not adhered to, can be catastrophic to the Split-Funded Defined Benefit strategy.
Since its inception, Life Insurance Strategies Group has solely focused on the individual high net worth life insurance market. We do not sell products. This allows us to offer unbiased, pragmatic advice. Visit us at www.lifeinsurancestrategiesgroup.com.