Life Insurance In A DB Plan: An Extra Benefit For Self-Employed

Many life insurance agents are unaware of the fact that a life insurance policy can be purchased inside a defined benefit plan. The premiums for the policy are paid from the contributions made to the defined benefit plan. Because these are pretax contributions, the premiums are also deductible.

Even though this sounds like a good idea, insurance inside a DB plan is highly regulated, and great care must be taken while purchasing a policy within a DB plan. I am not discussing 412(e) plans in this article, as those are fully funded by life insurance and annuity contracts. These days, DB plan participants want to have a market exposure as well as the ability to invest a portion of the money while also purchasing life insurance in the plan.

Let’s delve deeper into these concepts with a brief overview of the technical aspects.

DB plans come in various sizes. For the purpose of this article, we will refer to DB plans maintained by self-employed individuals or small-business owners.

Given all the negative press surrounding DB plans, it may seem surprising that small-business owners would set one up. However, a DB plan is the only retirement plan that can allow self-employed individuals to contribute thousands of dollars each year while receiving tax benefits.

This gives them the opportunity to catch up on retirement savings if they didn’t already save enough in their earlier days. These plans are extremely popular with medical offices, law practices or any business with significant free cash flow.

DB Plans: A Brief Overview

A DB plan is based on the individual participant’s age and the compensation. Let’s assume we have a small-business owner with no employees whose business is incorporated as an S corporation Based on IRS guidelines, only W-2 compensation can be used for compensation purposes, and the maximum amount that can be used for calculations is $285,000 for 2020. A business owner with at least $285,000 in W-2 compensation for three consecutive years and at least 10 years to retirement can accumulate $2.85 million in the DB plan, based on the mortality tables for 2020.

The IRS permits a business owner to earn a maximum of 100% of their compensation as income from a retirement plan subject to limits imposed by Section 415. The actuary then uses IRS-prescribed mortality tables to estimate the life span and calculate the amount of money the DB plan needs to have when the participant retires. This amount is typically referred to as the “lump sum at retirement.”

These numbers hold true for large groups, but the same concept is used for a single life DB plan. It is very likely that the participant may outlive their retirement savings or can die before exhausting the balance in the retirement plan. This is one of the reasons why DB plans for small businesses are better looked at from the perspective of being tax-saving instruments.

The actuary will then calculate the annual contributions that need to be made to the DB plan to fund the lump sum. The plan gives the business owner the flexibility to contribute more in the good years and lower the contributions when the business isn’t doing well. The plan may need to be amended from time to time so that the theoretical benefits in the plan equal the sponsor’s ability to contribute to the plan.

Life Insurance In The Plan

A portion of these contributions can be used to purchase a life insurance policy in the DB plan. The actuary needs to know whether the policy to be purchased is a whole life or a universal life insurance policy. The actuary will then use the highest three-year average of the participant’s compensation to determine the maximum lump sum that the participant can accumulate in the plan. This amount is then converted using actuarial equivalency to determine the monthly annuity the participant can get.

The maximum amount of life insurance face value that can be purchased in the plan is 100 times the monthly annuity benefit. The good news is that the actuary will do all of these calculations and neither the participant nor the agent needs to worry about the technical details. The life insurance agent only needs to coordinate with the insurance agency to determine the premiums that would be applicable for the participant based on age and health conditions.

There are other methods to determine the amount of premiums that can be paid from a DB plan, but they may put the client at the risk of an audit, as the face amounts can be significantly higher. With insurance in a DB plan, it is always beneficial to err on the side of caution.

Other Policy Considerations

A plan may purchase a life insurance policy as a means of providing a death benefit in the plan, so the death benefit must be “reasonable.” The life insurance policy should also be incidental to the main purpose of providing retirement benefits. These principles are adhered to when the policy face value is less than the maximum face value calculated by the actuary. Life insurance provides a higher death benefit in the early years of the plan, and the death benefit amount in excess of the policy cash surrender value is free from income tax to the beneficiary.

Plan Termination

The DB plan needs to be terminated when it has reached its full potential. Small-business owners typically prefer to take a lump-sum payment from the plan, instead of a monthly annuity, and roll it over into an individual retirement account. This saves them the annual cost of maintaining the plan in retirement. Large DB plans may or may not offer a lump sum option, based on the funding status of the plan.

An IRA typically cannot hold a life insurance policy, and there are a couple of options that can be exercised. The policy can be surrendered to the company for its cash value, which can be rolled over to an IRA along with the other investments. This would eliminate the death benefit for the participant.

Another option would be to distribute the cash value of the policy, but this would be a taxable event and the tax amount could be significant. The third option is for the participant to buy out the cash value from the plan by depositing an amount equal to the cash value. The participant would now be the owner of the policy, and the entire cash proceeds in the plan can then be rolled over into an IRA. Some participants also establish an irrevocable trust that purchases the life insurance policy at plan termination as a part of their estate planning.

DB plans are complex to administer, and an actuary is required to certify the funding status of the plan annually. Actuaries will typically charge an annual administration fee to ensure that the plan remains compliant with all IRS regulations. Agents are always better off working under the guidance of the actuary while purchasing a life insurance policy inside a DB plan.

Shrideep Murthy, CFA, is a manager at Pension Associates with significant experience in designing and administering defined benefit plans for small-business owners and self-employed individuals. Shrideep may be contacted at [email protected].