Life and Death Planning for Retirement Benefits

Chapter 11: Insurance, Annuities, and Retirement Plans

475

The IRS generally requires that life insurance policies be either converted to cash or distributed to the participant at retirement. This is one of the constellation of plan qualification requirements known as the “incidental death benefits rule,” the gist of which is that a retirement plan is supposed to provide retirement benefits , and may provide death benefits only to the extent they are “incidental.” See Rev. Rul. 54-51, 1954-1 CB 147, as modified by Rev. Ruls. 57-213, 1957-1 CB 157, and 60-84, 1960-1 CB 159, and ¶ 1.4.05 . Disposing of the plan-owned policy at or before retirement is popularly called the “rollout” of the policy (not to be confused with a “rollover!”). There are three ways the plan can dispose of the policy: distribute it to the participant; surrender it to the insurance company; or sell it to the participant or beneficiary. If the life insurance policy is distributed to the participant, the policy’s fair market value, less the amount of his investment in the contract ( ¶ 11.2.05 ), becomes gross income to him. See ¶ 11.3.02 . He can not roll over the policy to an IRA; an IRA cannot own life insurance. ¶ 11.4.05 . If the policy is surrendered to the insurance company, the plan receives the cash value from the insurance company. The participant could then leave those proceeds in the plan, or roll them over to an IRA, thus continuing tax deferral on the policy’s value. However, he would lose the insurance protection provided by the policy. His “investment in the contract” disappears under this scenario; he cannot apply it to subsequent cash distributions from the plan. ¶ 11.2.05 . Selling the policy to the participant or to the beneficiaries requires the parties to navigate the “transfer for value” ( ¶ 11.4.02 ) and “prohibited transaction” ( ¶ 11.3.05 , ¶ 11.3.07 ) rules. In contrast, if the employee buys his life insurance outside of the plan to begin with, these complicated issues at retirement simply do not arise. When a QRP distributes a life insurance policy to the insured participant, the value of the policy (minus the participant’s investment in the contract, if any; ¶ 11.2.05 ) is includible in the participant’s income. Reg. § 1.402(a)-1(a)(1)(iii) . Prior to February 13, 2004, the “value” of a life insurance policy for this purpose was either the policy’s cash surrender value (CSV) or in certain cases the policy reserves. See Reg. § 1.402(a)-1(a)(2) (pre-amendment), Notice 89-25, 1989-1 CB 662, A-10. For policy distributions after February 12, 2004, the amount includible is the policy’s fair market value (FMV). The “policy cash value and all other rights under such contract (including any supplemental agreements thereto and whether or not guaranteed) are included” in determining FMV. Reg. § 1.402(a)-1(a)(1)(iii) , as amended 8/29/2005. Rev. Proc. 2005-25, 2205-17 I.R.B. 962, provides a safe harbor formula for valuing a life insurance policy distributed by a QRP for purposes of Reg. § 1.402(a)-1(a)(1)(iii) . There is one version of the formula for nonvariable contracts and one for variable contracts (as defined in § 817(d) ). For both types of policies, the safe harbor value is “the greater of A or B.” “A” is the same for both types of contracts: It is the sum of the interpolated terminal reserve (a number that must be obtained from the insurance company) and any unearned premiums, plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year based on company experience. “B” differs depending on the type of policy; it is a formula that can be summarized as “PERC” (Premiums + Earnings - Reasonable Charges) times a certain permitted factor for surrender charges. The formulas basically disallow excessive, waivable, or “disappearing” surrender charges as an offset against value. How to determine policy’s FMV: Rev. Proc. 2005-25