Life and Death Planning for Retirement Benefits

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Life and Death Planning for Retirement Benefits

For the estate tax-conscious client, an important consideration in buying life insurance is to keep the insurance proceeds out of the insured’s estate (and the estate of his spouse, if any), to increase the value of the benefits for subsequent beneficiaries (typically the client’s children). If the policy is purchased outside the retirement plan, it is easy to accomplish this goal: The client creates an irrevocable trust for the benefit of his intended beneficiaries; and the trust buys the policy. The policy proceeds are never part of either spouse’s estate. If the policy is bought through a retirement plan, in contrast, it is doubtful whether the proceeds can be kept out of the estate of the participant. Generally, the estate tax treatment of retirement plan benefits is governed by § 2039 . However, § 2042 governs the estate tax treatment of life insurance, even if the insurance is held inside a retirement plan. § 2039(a) . Life insurance is subject to estate tax if it is payable to the insured’s estate, or if the insured owns any “incident of ownership.” § 2042 . To keep plan-held life insurance out of the participant’s estate, therefore, it is necessary to deprive the participant of such “incidents of ownership” as a five percent or more reversionary interest in the policy and the powers to name the beneficiary of the policy or surrender or borrow against the policy. § 2042(2) ; Reg. § 20.2042-1(c)(2) . Some practitioners believe this goal can be accomplished by establishing a “subtrust,” defined as “an irrevocable life insurance trust slotted within the trust otherwise used to fund the pension or profit sharing plan” (from “The Qualified Plan as an Estate Planning Tool,” by Andrew J. Fair, Esq., published by Guardian Life Insurance Company of America, New York, NY, 1995, Pub. No. 2449). The merits of the subtrust have been debated in numerous publications. See Zaritsky, H., and Leimberg, S.R., Tax Planning with Life Insurance (see Bibliography ), sections 6.08[2][f] and 6.08[4][b], and articles cited in the Bibliography . Some authors conclude that the subtrust works to keep policy proceeds out of the estate, without disqualifying the underlying retirement plan. Others argue that either the existence of the subtrust disqualifies the plan, or, if the plan is qualified, it is impossible for the participant not to have estate-taxable incidents of ownership in the policy. To date, there is no published ruling or case either upholding or denying estate tax exclusion for life insurance held in a retirement plan subtrust. However, in an unpublished IRS private letter ruling (technical advice memorandum) the IRS apparently opined that the existence of a “subtrust” would disqualify the retirement plan of which it was a part! The basis for this conclusion was that the subtrust’s assets could not under any circumstances be used to provide retirement benefits under the plan. Although this TAM was never officially issued by the IRS, and although the plan and subtrust discussed in the ruling had many unique features that make this ruling not necessarily applicable to all subtrust arrangements, use of the subtrust device must be considered risky. For discussion of this unpublished TAM, see Steve Leimberg’s Employee Benefits and Retirement Planning Email Newsletter - Archive Message #385 (September 19, 2006), and “Subtrust Triggers Plan Disqualification,” by Choate, N., Leimberg, S., and Zaritsky, H., Tax Notes, Vol. 113, No. 8 (11/20/06), p. 753. Because the subtrust may not work to keep policy proceeds out of the insured’s estate, and/or may disqualify the entire retirement plan, it is not recommended unless a favorable IRS ruling is first obtained. Even if the subtrust device does keep the death benefit out of the estate if the participant dies prior to retirement, new problems arise once the participant reaches retirement. If he then either buys the policy out of the plan or receives it as a distribution the participant is right back in the position of owning the policy.