Estate and Tax Planning for Qualified Plan Assets using Life Insurance

Estate and Tax Planning for Qualified Plan Assets using Life Insurance Executive Summary
This article discusses and compares a wide range of planning options for maximizing and transferring qualified plan assets from a plan participant to his or her heirs. For demonstrative purposes, the focus of the article is on a hypothetical qualified plan participant, age 70, who does not require any portion of her $500,000 IRA to fund her retirement lifestyle. Her desire is to leave the IRA money to her heirs as efficiently as possible. The options reviewed herein range from simply taking required minimum distributions to purchasing life insurance inside a profit sharing plan. The article argues that the best technique for accomplishing the participant's goal is a combination of a qualified single premium annuity supported with permanent life insurance. Financial advisors and their clients should consider the numerous tax consequences of qualified plan ("QP") assets owned by wealthy individuals. A QP, due to long-term tax-deferred growth, is a beneficial and effective vehicle for asset accumulation. It is, however, a troublesome asset for a divestment minded QP participant with a large estate (defined in this article as one that is subject to federal estate tax and, possibly state succession tax). Not only is the QP owner (the "participant") compelled to take required minimum distributions ("RMDs") from the QP while he or she is living, but at death the remaining balance in the QP is subject to estate and income taxes. Many QP participants are unaware that the government is often the majority beneficiary of their QP. Without proper planning, a QP beneficiary may receive as little as 30 percent (depending on the federal estate tax, state succession tax, and the income tax rate of the beneficiary) of the QP's assets. The ability to offer solutions to this vexing problem creates an opportunity for tax and financial advisors. This article will address how financial products, including life insurance, can be part of the solution. It will also briefly discuss why two planning techniques, the so-called "Stretch IRA" and "Pension Rescue," may not be viable or desirable for many participants.

Current Tax Environment
Tax and estate planning with QP assets requires flexibility in light of uncertainty concerning the estate tax; ambiguity regarding valuation of life insurance policies;1 and the future liquidity needs of the participant and/or the participant's heirs. Two QP planning strategies, the "Stretch IRA"2 (a technique for "Multi-Generational" planning) and Pension Rescue3 are not suggested herein as solutions. Stretch planning is best utilized where the participant's estate has adequate liquidity to pay the estate tax due on the QP, and where the heirs desire to receive the money over a long time (the life of the heir). Moreover, recent Private Letter Rulings 200228025 and 200413011 have muddied the waters, and may complicate a positive aspect of stretch planning; that is, allowing younger heirs to receive money over their individual life expectancies, rather than that of the eldest heir.4 Stretch Planning's primary disadvantage is that it only defers the income tax, but it can, nevertheless, be effectively utilized with a primary solution.

Pension Rescue,prior to recently issued Proposed Regulations, Sections 1.79-1, 1.83-3, and 1.402(a)-1, 69 Fed. Reg. 7354 (Feb. 17, 2004), Revenue Procedure 2004-16, and Revenue Procedure 2005-25, contemplated a profit sharing plan purchasing a life insurance policy using QP assets and transferring the policy to a third party, such as a trust, for the policy's fair market value ("FMV"). Frequently, taxpayers relied upon the cash surrender value, the tax reserve value or (for whole life policies) the interpolated terminal reserve as the policy's FMV. The cash surrender value often was significantly less than the premiums paid at the time of the transfer. The Service, in Revenue Procedure 2005-25, permits a taxpayer to rely on a safe harbor value to meet the definition of FMV for a policy sold or distributed from a qualified plan5. For many policies, the safe harbor value will likely approximate the cash accumulation value for 'seasoned' policies, and the premium paid through the date of transfer for new policies. Certain aspects of the formula set forth in 2005-25 determining the safe harbor FMV are unclear. Moreover, the Service added an anti-abuse provision to preclude the artificial reduction or lowering of a policy's cash values (ostensibly via unreasonably high mortality, surrender or other charges). Consequently, this article will focus on planning strategies other than Stretch Planning and Pension Rescue.

The Client
For our example, assume the participant has a taxable estate of which $500,000 is a rollover IRA invested in a fixed income portfolio. Further assume that the participant is a widow, in good health, age 70, and does not need the QP money for her retirement. Her effective federal income tax rate and that of her children is 28 percent. She wants to maximize the amount of QP money that her heirs will inherit. Assume that the IRA assets will grow at a rate of five percent and that any RMDs will also grow outside the IRA at five percent, before tax. The participant's children are the designated beneficiaries of her IRA and are the sole beneficiaries of any probate assets.

Option 1-Do Nothing.
Under the "Do Nothing" option, the participant does no planning and simply withdraws her RMDs each year. This option is generally the default option for those participants without planning, which greatly benefits the government. For example, if the participant dies in year one, her heirs would receive about $180,000 of the $500,000, after federal estate and income tax. This assumes that the heirs withdraw the IRA assets, which are income in respect of the decedent, to pay the estate tax. If the participant dies at age 85, the heirs would receive between $170,000 and $310,000. The $170,000 is the net (after estate and income taxes) QP balance. The cumulative RMDs after income tax would be $280,000. After payment of an assumed 50% estate tax, the RMD money (if not spent by the participant while alive) passing to the heirs would be $140,000.

The obvious disadvantage of this option is that the participant is not maximizing the amount that will pass to her heirs, which is her primary goal. Another disadvantage is the uncertainty of how much money her heirs will receive.

The advantage is the existence of total flexibility as the participant has complete and direct access to the QP, in the event she decides she needs or wants the money for her own benefit.

Option 2-Immediate Lump Sum Distribution with Life Insurance.
Under this option, the participant would take an immediate distribution of the $500,000 and pay the income tax thereon. The after-tax balance would be $360,000. This assumes that the effective tax rate does not increase as a consequence of the inclusion in one year of such a large amount of income. That sum will be gifted or loaned to an irrevocable life insurance trust ("ILIT") set up as a grantor trust. It can be an access ILIT where the trustees have the ability, with respect to any life insurance policy owned by the ILIT, to take withdrawals and/or loans from the policy. The trustees should also have the ability to make arm's length loans to third parties, including the beneficiaries and the participant. Proper drafting and implementation are required to insure that the participant does not have any incidents of ownership in the policy.6 The ILIT will apply the $360,000 to purchase a life insurance policy on the participant.7

Depending on the facts and circumstances, either whole life or universal life ("UL") can be used. Here, the policy is a typical non-guaranteed UL contract that assumes a five percent current rate, has surrender charges for 15 years, is (due to the large lump-sum premium) a modified endowment contract,8 and has extended maturity (to age 120) of death benefit. The death benefit is $1,140,000 (the death benefit can and will vary, depending on the carrier selected, type of policy, guarantees, and any riders selected). A so-called no-lapse UL with secondary guarantees will generally result in a greater death benefit than a traditional UL contract. A guaranteed no-lapse UL may be appropriate where the owner can and will pay the premiums in a timely manner, where the policy is a modified endowment contract, or where death benefit is the sole consideration. If the participant is younger or desires a policy with greater cash value, whole life might be a better option.

For this illustration, the participant has a 'select' rating, which, for the subject carrier, has a lower cost of insurance than a 'standard' rating, but a higher cost of insurance than if she had an "ultra select" rating. Under this option, the heirs will receive, regardless of the date of death of the participant, $1,140,000. If there are no incidents of ownership, the proceeds will be excluded from the taxable estate.

The advantage of this option is that the heirs will receive substantially more than they would under option 1.

The primary disadvantage is the "cost" of gifting the funds to the ILIT to purchase the policy because it is unlikely that there will be enough annual exclusions to cover the gift. Therefore, the participant, assuming the money is gifted to the ILIT, has to utilize a portion of her lifetime unified (gift tax) credit or pay the gift tax. Another disadvantage to the participant is that she relinquishes direct access to the QP money because it is now inside the policy in the form of cash values. Through the so-called "access" ILIT, the participant has indirect access to the policy's cash surrender value via loans from the ILIT to the participant (at the discretion of the ILIT's trustee). The ILIT could also provide for distributions for the benefit of the beneficiaries for their health, support, and education. However, because the policy is a modified endowment contract, accessing cash is not tax efficient. A potential problem, and certainly a consideration, would be if the $500,000 in income would place the participant in a higher bracket for the year in question. If so, the net distribution would be less, which, in turn, would result in a decreased death benefit.

An alternative to a lump sum distribution is to take distributions over, for example, five years. This would likely preclude the participant from being in a higher bracket when the money is withdrawn. It also increases the likelihood that annual exclusions using Crummey powers could cover the gift of the funds to the ILIT. The death benefit, however, will be less than if the entire premium were paid year one.

Option 3-Level Distributions and Life Insurance.
Under this option, the participant will (to the extent the funds exist) withdraw a predetermined level amount each year from the QP, pay the tax thereon, and gift the net amount to the ILIT for the purchase of life insurance. An annuity payout indicates that at the assumed five percent rate of return, the participant can withdraw $30,000 annually for 30 years. After income tax, the amount gifted to the ILIT for annual policy premium would be $21,600. The $21,600 annual premium will support a policy of $840,000 (applying the identical policy facts and assumptions as set forth in option 2). Under this approach, the heirs will receive the full $840,000 of death benefit. The heirs also will receive the net date of death balance of the QP (here is a situation where Stretch Planning can be effectively employed). The net amount to the heirs will gradually decrease each year as the QP is depleted by the $30,000 annual distribution. After 30 years, under the assumptions, the QP will be completely exhausted. In year one, the heirs would receive about $1,023,000 comprised of the death benefit and the net after tax proceeds from the QP. If the participant dies at age 85, the heirs would receive about $973,000. If death occurs at age 100, the heirs would receive only the $840,000 of death benefit.

The advantage of this option is that the heirs receive a significant sum, less than under option 2 but more than under option 1. The design is flexible as the participant has direct access to the QP, as well as indirect access to the policy's cash values. An additional benefit is that the annual cost of transferring the funds ($21,600) to the ILIT will likely be within the annual gift tax exclusion, thus preserving the unified credit. Moreover, the participant maintains complete control over the QP investments, and can potentially achieve a higher rate of return than that assumed herein.

The risk with this design is that it assumes a five percent return in the QP each and every year to generate the annual $30,000 distribution for 30 years. This is certainly a reasonable expectation, but any downside deviation will reduce the amount available for distribution. With less money from the QP for premiums, the policy may lapse unless the ILIT reduces the death benefit and/or pays additional premium.

Option 4-Qualified Annuity Equals Steady Cash Flow.
Under this option, the participant applies the $500,000 in the QP to purchase a qualified annuity. The income stream from the annuity, which satisfies the RMDs, is used to purchase life insurance. The annuity will be a single premium immediate annuity, known as a SPIA. A SPIA can generate fixed payments to its owner each year (or month) while the owner is alive. It stops payment upon the death of the participant. Middle-class people, especially those in good health, may purchase a SPIA to make sure that they do not outlive their money. As indicated below, a wealthy person can successfully employ a SPIA when it comes to QP tax planning.

SPIA payments, which are based on the actuarial life expectancy of the participant and the interest rate established by the carrier, are established at inception. Carriers assume that a participant will not live to age 100, so the annual cash flow from the SPIA, which is a guaranteed payment,9 will exceed the level annual distribution assumed in option 3. The annual guaranteed lifetime payment from the SPIA for our participant is $40,800 (the amount will vary depending on the issuer). After income taxes, the net amount to be transferred to the ILIT is $29,160. That annual premium will purchase $1,200,000 of death benefit (again using a non-guaranteed UL policy). The life insurance policy and the SPIA are purchased from different companies. Advisors should be cognizant that a SPIA can work, and may actually be very effective, if a participant is not in perfect health, but is still insurable. Some carriers issue what is known as a rated SPIA, which offers a higher payout if the carrier determines the participant has a reduced life expectancy. The higher payout might allow the purchase of additional life insurance in the event a different carrier offers a favorable medical underwriting decision (perhaps that the insured has a normal life expectancy).

Under this option, the heirs will receive the $1,200,000 of death benefit. If the participant attains age 100, the heirs would actually receive a slightly greater sum, as the policy no longer requires premium and the SPIA would still pay the participant.

The primary advantage of this option is that the heirs receive more money than they would than in any of the other options. The participant still has direct access to the annuity payouts and indirect access to the policy's cash value. The amount gifted to the ILIT each year is likely to be within the annual gift tax exclusion. Also, at inception, the $500,000 QP is no longer part of the participant's taxable estate, as it was removed from the estate.

The disadvantage of this approach is that the participant forfeits the ability to access the QP principal and that the participant locks in a low rate of return with the SPIA, which makes this option more appealing for older participants.

Option 5-Purchase the Policy Inside the Qualified Plan.
Under this option, which is not suitable for all participants, the participant would purchase life insurance inside the QP. If the participant has earned income that she expects to continue, she can create a profit sharing plan. A properly designed profit sharing plan may purchase and own life insurance on the participant. A profit sharing plan may be structured to use all the money from another QP that is rolled into the profit sharing plan to purchase life insurance.

A $500,000 lump sum premium will purchase $1,700,000 of coverage. The participant can pay the premium in installments, but this results in less coverage. By using pre-tax dollars to purchase the policy, the amount of death benefit is maximized (as compared to option 2). There are a number of tax consequences, however, that must be considered with this approach. Upon the death of the participant, assuming the profit sharing plan still owns the policy, the death benefit is inside the QP and subject to the double tax (part of the death benefit is subject to income tax and all the death benefit is subject to estate tax). Furthermore, each year while the policy is in the QP, the participant pays income tax on the 'term cost' of the coverage that is "at risk" (the difference between the cash value and the death benefit). This amount is known as the reportable economic benefit ("REB").10

For example, the first year the amount at risk is $1,204,271 ($1,700,000 less cash value of $495,729). The term cost for REB purposes will likely be based on the Table 2001 rates.11 See Table 2001, which is Exhibit I. For an insured age 70, the cost of one-year term protection under Table 2001 is $20.62 per $1,000 of coverage. Thus, the REB for the first year would be $24,832. This sum is phantom income to the participant, and at the assumed income tax of 28 percent, she would owe tax of about $7,000. One positive note is that she is reducing her taxable estate by the $7,000 without: 1) reducing the amount that will pass to her heirs and 2) paying gift tax. The Table 2001 rates increase gradually so that at age 85, the cost is $88.76 per $1,000 of coverage. That results in a REB of $88,084. Should the tax due on the REB become prohibitive, the participant will have a number of options: 1) reduce the death benefit (one reason for using a UL policy is that some products allow death benefit reductions without assessing charges), 2) sell the policy to heirs or an ILIT for the policy's FMV (the measure of FMV is presently unclear but, under 2005-25, appears to be close to the cash accumulation value), 3) receive the policy as a distribution and pay income tax on the FMV or 4) surrender the policy or sell it on the secondary market.

If the policy is sold to a third-party other than in the secondary market, care must be taken so that the sale is not a prohibited transaction under ERISA (ERISA 406 (a)(1)(A)) or a transfer for value (IRC Section 101 (a)(2)). The sale of the policy from the QP to the participant, a relative of the participant, or a grantor trust for the benefit of the participant or a relative of the participant is not a prohibited transaction. If the policy is sold to the participant or partner of the participant it is not a transfer for value. Therefore, if the sale is to a grantor trust, the participant and the trust should be partners (in advance of the sale) in a private or publicly traded partnership.

At the participant's death, the at-risk amount on the date of death is received income tax free by the beneficiary. See IRC Section 101(a). Next, the total of the REB costs on which the participant/insured paid tax should be recovered income tax free. See Treasury Regulations Section 1.72-16(b). The balance will be taxed at ordinary income as a customary QP distribution.

There is also the estate tax to consider. The participant is single so there is no marital deduction (this option is significantly more attractive to a married participant with a younger or healthier spouse). Under IRC Section 2042, the entire death benefit is subject to estate tax.

A participant must still comply with the RMD rules. If the participant did not have other QP assets, then all the money could not be used for the life insurance (without the policy being invaded each year to pay the RMDs). Not only are there numerous tax consequences to address, there is currently too much uncertainty with respect to the cost of the REB and the FMV of a policy for this option to be attractive. Consequently, this option, for this participant, is arguably superior only to option 1.

Many QP participants do not devote the necessary time and energy to explore the planning possibilities with QPs, which can turn a problematic tax asset into significant family wealth. Advisors must pay careful attention in determining the various income, gift and estate tax consequences of utilizing life insurance with a QP. The table at, Exhibit II, summarizes options 1&4. Each option discussed in this article has certain advantages and risks. Deciding which option(s) to employ should be made on a case-by-case basis after considering both the tax results and non-tax needs of the participant. The advisor, by applying the unique facts and circumstances of each client to the various options, can readily and clearly demonstrate to the client the merits of using financial instruments as a vehicle to effectively maximize and transfer QP assets.


1 The Treasury Department, on February 13, 2004, issued proposed Regulations and a Revenue Procedure (2004-16) regarding the fair market value of a life insurance policy that is distributed from a qualified plan or paid as compensation from a service recipient to a service provider (under IRC Section 83). Subsequently, on April 8, 2005, the Service issued new life insurance valuation rules in Revenue Procedure 2005-25, which supersedes Revenue Procedure 2004-16.
2 IRA 'stretch' planning is a common name given to a technique where a participant's designation of beneficiaries is done in such a manner so that heirs, often children or grandchildren of the participant, can take distributions from the QP over the heir's life expectancy upon the death of the participant so as to benefit from an extended period of tax-deferred growth. While the author does not generally advocate Stretch Planning as a primary solution, it certainly may be advisable where a participant is uninsurable.
3 Pension Rescue, to the best of the author's knowledge, is a registered trademark owned by Professional Financial Services, LP.
4 In PLR 200278025, the participant died before taking required minimum distributions. A trust for the benefit of grandchildren was designated beneficiary of the IRA. Under the terms of the trust, if a grandchild had no issue at death the assets passed to contingent beneficiaries, the oldest of which was an uncle, age 67. The IRS ruled that the RMDs to the grandchildren had to be based upon the uncle's life expectancy.
5 The safe harbor value fair market value (FMV) under 2005-25 for a traditional universal life policy sold or distributed from a qualified plan is the premium paid from issue to the transfer date, less reasonable mortality and other charges. 2002-05 provides for partial recognition of surrender charges for a policy distributed from a QP. The above figure is then multiplied by the applicable surrender factor, which is .7. Presently, there is uncertainty as to what charges are reasonable and how the word "reasonable" is to be construed.
6 Proceeds of life insurance are included in an insured's gross estate if the insured legally possessed and could exercise any incidents of ownership of a life insurance policy insuring his/her life at the time of death. IRC Section 2042 (2). Incidents of ownership include, but are not limited to, the rights to: name a beneficiary, surrender or cancel a policy, assign a policy, revoke an assignment, and take a policy loan or withdrawal. Treasury Regulation 20.2042-1(c)(2).
7 Universal life insurance is known as flexible premium life insurance. Premiums are not fixed as to amount or time of payment. Many universal life products offer guaranteed death benefit and cash value. Some also offer full coverage beyond age 100. For these reasons, and because universal life will generally offer a greater death benefit relative to the premium when compared with a whole life policy, universal life is more attractive for the type of planning discussed herein.
8 If a policy is a modified endowment contract (one that fails what is known as the 7 pay test under IRC Section 7702A(b)), it is taxed as if it were an annuity. Distributions, including loans, are taxable to the extent of gain. Gains are taxed first and return of basis follows. Distributions from a MEC may also be subject to a 10 percent penalty. Tax on the gain would be paid by the ILIT unless it is a defective grantor trust. It may be prudent in policies with significant cash values, where access to such cash in excess of basis is contemplated, to avoid the policy being a MEC by the use of a term rider.
9 A "guaranteed" SPIA payment is predicated on the solvency of the sponsor/carrier. Payments are not secured by any governmental guarantees.
10 See IRC Section 72(m)(3)(B) and Treasury Regulation 1.72-16(b).
11 The term costs for annual life insurance protection under Table 2001 were set forth in IRS Notice 2001- 10, 2001-1 CB 459. In limited circumstances, a taxpayer may rely on a carrier's alternate term rate or annual renewal term even if lower than Table 2001.