Don’t overlook life insurance in a qualified retirement plan

Life insurance in its basic form is a death benefit to provide financial security to loved ones, those you care for or who are dependent on you — a way to instantly provide financial security. However, life insurance has evolved, taking on many forms and providing for many needs.

Those of you in the business market may think premiums are tax-deductible if the employer is bonusing the key employee through an Internal Revenue Code Section 162 bonus arrangement. No. The premiums are not deductible.

The cash bonus to the key employee, whether paid directly to the employee or the insurance carrier, is deductible, and the employee pays tax on that bonus. A technical splitting of hairs, yes, but an important one.

The overlooked opportunity

The opportunity exists for tax deductions in an employer-sponsored qualified retirement plan such as a defined contribution plan (most prevalent is a profit sharing 401(k)) or a defined benefit plan. The opportunity exists whether there is an existing plan or the employer is establishing a new plan.

The IRC allows the use of life insurance in a retirement plan if it is incidental to the primary purpose of providing retirement benefits.

Therefore, life insurance may be purchased with tax-deductible (pretax) dollars if the premiums are less than 50% (using permanent whole life insurance) or not more than 25% (if using permanent insurance other than whole life or universal life).

Why life insurance in a qualified plan?

If there is a need or want for life insurance, it may be purchased with tax-deductible (pretax) dollars in a qualified plan. Here are some of the advantages:

• Access to insurance. Life insurance offered through the plan may be the only way some participants can obtain or afford life insurance protection. With the plan, there is access through payroll deductions or employer contributions. In some cases, a pool of seasoned or aged funds can also be used to provide such coverage.

• Survivor benefit. All plans have a death benefit. It is simply the accumulated vested account balance. However, including life insurance in the plan provides an exponential death benefit immediately. Survivors receive the accumulated vested account plus the life insurance.

• Favorable underwriting. In some cases, the life insurance may be issued on a simplified or guaranteed issue basis with limited or no medical underwriting.

• Policies available on a gender-neutral (unisex) basis.

• Asset allocation. Permanent life insurance may be considered like any other major asset class and both acquired and managed according to an asset allocation for long-term value and maximization of benefits. Life insurance is not correlated to the markets and has aspects similar to a quality bond.

• Guarantees. Subject to the claims-paying ability of the carrier, the death benefit and the contractual guarantees are certain. Additionally, dividends may be paid if the carrier’s board of directors declares them.

• Income-tax-free death benefit. The face amount minus the cash value is paid to the beneficiaries free of income tax. The cash value, as with the other investments in the account, is taxable or may be transferred or rolled over to an individual retirement account.

• Portability. The employee may continue the policy beyond separation from service. Several options are available, but some have tax consequences.

Tax benefit and cost

If the life insurance premium in the plan is paid for with employer contributions, there is no Social Security and Medicare (FICA) withholding. Unlike elective deferrals in a 401(k) arrangement or contributions in a Roth 401(k) arrangement, which are subject to FICA, employer contributions are not subject to such withholding.

Considering the pretax ability of premium payment, let’s look at a simple example. Assume a 35-year-old employee earning $100,000 in a 35% tax bracket and contributing 6% is offered life insurance as part of the investment lineup in their 401(k).

The employee also needs life insurance but is finding it hard to come up with the discretionary dollars to pay for the premium of $2,000 per year. Mathematically, the problem is exacerbated by the fact that in a 35% tax bracket, the employee needs to earn approximately $3,076 to pay the premium after taxes.

However, inside the plan, the cost is approximately $1,300 and the reportable cost to the employee is the economic benefit, which is the tax on the one-year term cost.

Hypothetically, if a $2,000 premium purchases a face amount of $120,000 of permanent whole life insurance, the economic benefit, using the IRS rate, is $118.80 (the Table 2001 rate for a 35-year-old is $0.99). Therefore, the employee would pay tax of $41.50. For $120,000 of permanent life insurance, the cost to the employee is $41.50. Would you rather pay $2,000 or $41.50?

Ernest J. Guerriero, CLU, ChFC, CEBS, CPCU, CPC, CMS, AIF, RICP, CPFA, national president of the Society of Financial Service Professionals, is the director of qualified plans, business markets for Consolidated Planning. He may be contacted at [email protected].