Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
What is it?
Qualified plan purchases and owns life insurance on
employee using deductible employer contributions to
the plan to fund purchase
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
When is it indicated?
• large number of employees covered under qualified
plan have unmet life insurance needs
• have gaps or limits on other company plans that
provide death benefits
• want contribution option that would provide tax
deduction when qualified plan is over funded or close
to full funding limitation
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
When is it indicated?
• highly compensated plan participants face substantial
estate taxes on death benefits
• life insurance could provide plan participants an
additional option for investing their plan accounts
• employer wants secure funding vehicle for plan
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Advantages
• favorable tax treatment as compared with individual
life policies provided by employer outside qualified
plan or personally owned life insurance
• safe investment
• predictable plan costs
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Advantages
• retirement benefits guaranteed by insurance
company as well as employer
• death proceeds less policy cash values (pure
insurance portion of policy) not subject to income tax
• may be able to structure insured plan death benefits
to avoid estate tax at participant’s death
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Advantages
• exemption of fully insured from minimum funding
standards and actuarial certification requirements
reduces administrative costs and reduces complexity
of defined benefit plan
• some life insurance companies provide low cost
installation and administrative services if plan uses
their investment products, further reducing cost
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Disadvantages
• relatively low rate of return
• policy expenses and commissions may be greater
than for comparable investments
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
How is it used?
Insurance Coverage
• should provide for all plan participants under
nondiscriminatory formula that is related to
either
–
–
retirement benefit
plan contribution formula
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
How is it used?
Insurance Coverage
• can condition coverage on medical exam IF this
requirement does not discriminate in favor of highly
compensated
• can minimize turnover costs with cash value
insurance
–
–
make waiting period for insurance longer than plan’s
waiting period for entry
use term insurance to cover interim
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
How is it used?
How Much Insurance – The ‘Incidental’ Test
IRS: any non-retirement benefit in qualified plan is
incidental as long as cost of benefit is < 25% of total
plan cost
Difficult standard to apply
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
IRS has developed 2 practical tests
1. participant's death benefit must be no more than 100
times the expected monthly benefit
2. Aggregate premiums paid for participant’s insured
death benefit are at all times less than these
percentages of plan cost for that participant:
“ordinary life” insurance
term insurance
Universal life
Copyright 2009, The National Underwriter Company
50%
25%
25%
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Life Insurance in Defined Benefit Plans
• adds to limit on deductible contribution
• in contrast, in defined contribution plan, life insurance
costs must be part of contributions to each
participant's account
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Common ways life insurance is used in
Defined Benefit Plans
• combination plan
• envelope funding
• fully insured plan
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Combination Plan
• Retirement benefits funded with combination of
–
–
whole life policies
assets in separate trust fund (‘side fund’ or ‘conversion
fund’)
• Approach combines advantages of
–
–
–
insured death benefit
investment security of policy cash values
aggressive investment of side fund assets
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Combination Plan
• Appropriate for smaller pension plans (< 25
employees)
• Death benefit for each employee usually determined
by 100-to-1 test
• Annual plan cost = required insurance premiums +
amount deposited in side fund that is determined on
actuarial basis
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Envelope Funding
• Insurance policies simply considered plan asset
• Actuary determines total annual contributions to plan
to provide retirement and death benefits under plan
• Employer makes contributions as determined by
actuary
• Plan trustee purchases assets – including insurance
policies – to fund cost of retirement and death
benefits
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Envelope Funding
• Keep amount of insured death benefit within
incidental limits by
–
providing death benefit no more than 100 times each
participant’s projected monthly pension
or
– keeping the amount of insurance premiums within
appropriate percentage limits
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Envelope Funding
• Requires lower initial contributions to plan than
combination plan approach
• Long term costs depend on
–
–
–
–
actual investment results
policy dividends
benefit
administrative costs of the plan
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Fully Insured Plans
Funded exclusively by life insurance or annuity
contracts
Regaining popularity after pension investors lured away
by high interest rates in 1970s and bull market of 1990s
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Overfunding Problem for
Qualified Defined Benefit Plans
Tax deductible employer contributions
–
–
must meet actuarially determined minimum funding
amount
cannot exceed “full funding limitation”
Law limits interest rates that can be used in determining
plan liabilities
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
A Solution – Fully Insured Plans
[IRC Section 412(i) plans]
Exempt from minimum funding rules
Avoids overfunding problem
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Plan is Fully Insured for Plan Year IF
• plan funded exclusively by purchase of individual
insurance contracts
• contracts can be
–
–
individual or group
life insurance, annuity contracts or combination
• have level annual (or more frequent) premiums
extending to retirement for each individual
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Plan is Fully Insured for Plan Year IF
• plan benefits are equal to the contract benefits and
guaranteed by licensed insurance company
• premiums paid without lapse or reinstated after lapse
• no rights under the contracts subject to security
interest during plan year
• no policy loans outstanding at any time during plan
year
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Fully Insured Plans
• must be nondiscriminatory regarding
–
–
–
rights
benefits
features
• benefit formulas of plans satisfying safe harbor and
specified uniformity requirements are considered
nondiscriminatory in
–
–
contributions
benefits
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Fully Insured Plans: Other Advantages
•
•
•
•
simplified ERISA reporting requirements
do not need certification by enrolled actuary
reduced cost and complexity of plan administration
exempt from requirement of quarterly pension
deposits but subject to Pension Benefit Guaranty
(PBGC) coverage and annual premium requirements
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Fully Insured Plans: How Does it Work?
• can be used with new or existing plan
• employer can be corporation or unincorporated
business
• typically uses group contract with individual accounts
for participants
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Fully Insured Plans: How Does it Work?
• insurance company guarantees all benefits
• premium based on guaranteed interest and annuity
rates; conservative estimates results in larger initial
deposits than in typical uninsured plan
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Fully Insured Plans: How Does it Work?
• use of excess earnings to reduce future premiums
means funding level high at beginning, resulting in
–
–
maximization of overall tax deduction
possibility of tax deduction for existing plan that has
reached full funding limitation with uninsured funding
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Life Insurance in Defined Contribution Plans
• part of each participant’s account can be used to
purchase insurance on the participant’s life
• insurance purchase can be
–
–
–
voluntary
provided automatically as plan benefit
provided at plan administrator’s option (on a
nondiscriminatory basis)
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Life Insurance in Defined Contribution Plans
• insurance amount must be kept within incidental
limits
• generally best to keep percentage contributions
under full limits to maintain investment flexibility and
employer ability to reduce contributions in lean years
• since IRS limit tests are computed in the aggregate,
may be able to purchase a considerable amount of
insurance in a later year
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Life Insurance in Defined Contribution Plans
• in-service cash distributions allowed in profit sharing
plans prior to termination of employment
• can be used without limit to purchase life insurance
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Tax Implications
1. if amount of life insurance within incidental limits,
employer plan contributions are tax deductible
2. economic value of pure insurance on participant’s life
is taxed annually to participant at levels specified by
the IRS; participant contributions are subtracted
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Tax Implications
3. taxation of insured death benefit
–
–
–
pure insurance part is income tax free to plan beneficiary
total of all Table 2001 (formerly P.S. 58) costs paid by
participant recovered tax free
remaining distribution taxed as qualified plan distribution
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Tax Implications
4. insurance in a plan usually provides tax advantages
not available for individual life policies provided by
employer outside qualified plan or personally owned
life insurance
5. may be possible to exclude insured portion of
qualified plan death benefits from decedent’s estate
for federal estate tax purposes
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Alternatives
1. personally owned life insurance
2. group-term life insurance
3. life insurance financing in a nonqualified deferred
compensation plan
4. split-dollar life insurance
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
True or False?
1. Life insurance provides one of the safest available
investments for a qualified plan.
2. To be nondiscriminatory, the same amount of life
insurance must be given to each employee.
3. Life insurance is advantageous in a defined
contribution plan because it adds to the limit on
deductible contributions.
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
True or False?
4. In combination plans, retirement benefits are funded
with whole life and assets in a separate trust fund.
5. Fully insured plans must be nondiscriminatory with
respect to rights, benefits, and features.
6. Split dollar life insurance is an alternative to life
insurance in a qualified plan.
7. Life insurance can be used in a Keogh plan.
Copyright 2009, The National Underwriter Company
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Life Insurance in a Qualified
Chapter 13
Employee Benefit & Retirement Planning
Plan
Discussion Question
What are the considerations in determining whether
fully insured funding is advisable from an economic,
investment point of view?
Copyright 2009, The National Underwriter Company
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