Life and Death Planning for Retirement Benefits

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Life and Death Planning for Retirement Benefits

Difference Between “Basis” and “Investment in the Contract” The Internal Revenue Code taxes “income.” When an individual sells or otherwise disposes of property in exchange for consideration, the resulting “income” that is subject to taxation is generally the gross consideration the individual receives minus the cost of the property, i.e., the amount the individual originally paid to get that property plus whatever amounts he invested in the property prior to disposing of it. When property is sold in a transaction taxable under § 61(a)(3) , the cost offset the taxpayer can deduct from the sale price to determine his gain is called his “basis.” § 1001(a) . In the case of insurance products, however, a different approach applies. Amounts the individual receives under the policy from the issuer are taxable under § 72 , not § 61 . § 72 allows an offset for the individual’s “investment in the contract” rather than his “basis.” Reg. § 1.72-6 . Tax afficionados tend to treat the two terms as interchangeable, and assume that (however the individual may dispose of the insurance policy, whether via surrendering it to the insurance company or selling it to a third party), the individual’s gain would be measured the same way. Rev. Rul. 2009-13, 2009-21 I.R.B. 1029, has exploded this notion, making it clear that a policy holder’s “investment in the contract” (relevant for measuring income under § 72 if the policy holder receives payments under the contract from the insurer) is not necessarily the same as his “basis” (used for measuring gain if the policy is sold to a third party). In particular, premiums paid for current insurance protection are included in “investment in the contract” but not in “basis.” So the sale of a policy to a third party may generate taxable gain even if surrendering the same policy in exchange for the same amount of money to the issuing insurer would not generate gain. Normally, life insurance proceeds are income tax-free to the policy beneficiaries. § 101(a) . However, when proceeds of plan-owned life insurance are paid to the beneficiaries, § 72(m)(3)(C) dictates that, to the extent of the policy’s cash surrender value (CSV) immediately prior to the participant’s death, the distribution is treated as a “retirement plan distribution” (taxable under § 402 ) rather than as a tax-free distribution of “life insurance proceeds.” Thus, to the extent of the pre-death CSV, life insurance proceeds are treated the same as all other retirement plan distributions, and are subject to income tax when paid out to the beneficiaries. Only the “pure insurance protection” portion of the distribution is tax-exempt under § 101(a) . Despite the fact that the participant might have been taxable on more than the CSV if the policy had been distributed to him during life (see ¶ 11.3.02 ), only the CSV is treated as gross income to the beneficiaries. Also, the beneficiaries are entitled to deduct the amount of the participant’s investment in the contract ( ¶ 11.2.05 ) from the amount otherwise includible in their gross income. See Reg. § 1.72-16(c)(3) , Example 1; Rev. Rul. 63-76, 1963-1 CB 23. For what happens to the investment in the contract if the policy is sold to the beneficiaries, see ¶ 11.3.06 ; on the participant’s death, see ¶ 11.2.06 . Income tax consequences to beneficiaries

11.3 Plan-Owned Life Insurance: The “Rollout” at Retirement

If the participant does not die while still employed, he must make some choices regarding the life insurance policy when he retires.

Options for the policy when the participant retires