Life and Death Planning for Retirement Benefits

Chapter 11: Insurance, Annuities, and Retirement Plans

481

The bottom line: If estate tax avoidance is important to the client, buy the life insurance outside of the retirement plan.

Avoiding estate tax inclusion and “transfer for value”

As discussed at ¶ 11.3 , the normal course is for the retirement plan to sell or distribute the policy to the participant at retirement. The participant may wish at that point to transfer the policy to his intended beneficiaries (or to an irrevocable trust for their benefit) to get the proceeds out of his estate for estate tax purposes. Since giving away the policy would not remove the proceeds from the participant’s estate until three years after the gift ( § 2035(a) ), practitioners look for an alternative way to get the policy into the hands of the beneficiary(ies) without the three-year waiting period. The obstacles to success in this endeavor are discussed in this ¶ 11.4.02 ; for further discussion of ways to deal with what its authors call this “vastly over-exaggerated problem,” see the article by Ratner, C.L., and Leimberg, S.R., “Planning Under the New Split-Dollar Life Insurance Prop. Regs., Part 2,” 29 Estate Planning 12 (Dec. 2002), p. 603, at 606. Since the plan cannot distribute benefits to anyone other than the participant during the participant’s lifetime, the only ways the policy can be moved from the plan to the intended beneficiaries without triggering the three-year rule are for the plan (1) to sell the policy directly to the beneficiaries, or (2) distribute or sell the policy to the participant who then sells it to the beneficiaries. The second method is safer, due to the IRS rule changes discussed at ¶ 11.3.03 . Another problem with selling the policy to the beneficiary (regardless of who is the seller) is the transfer-for-value rule of § 101(a)(2) . Life insurance proceeds (net of consideration paid for the policy) are taxable income to a recipient who acquired the policy in a transfer for value unless an exception applies. The beneficiaries’ purchase of the policy from the participant, or from the plan, would be a transfer for value, causing the eventual death benefit to be taxable income instead of tax-exempt income. Techniques practitioners use to avoid the transfer-for-value problem include selling the policy to a partnership in which the insured is a partner (see § 101(a)(2)(B) , PLR 2001-20007), or to a “grantor trust” (see § 671 – § 677 , Rev. Rul. 85-13, 1985-CB 184, and PLRs 2005-14001, 2005- 14002, 2002-47006). This subject is beyond the scope of this book. See Bibliography for other resources.

Second-to-die insurance

A plan’s ownership of a “second-to-die policy” (insuring the lives of the participant and the participant’s spouse) introduces additional complexity.

A. Estate tax minimization. If a second-to-die insurance policy is purchased outside the plan, the only legal paperwork required to avoid estate and gift tax is the drafting of one irrevocable trust to buy the policy, plus “Crummey” notices. If the policy is bought inside a retirement plan, on the other hand, one author recommends using a trust, plus either three or four separate life insurance policies, and possibly a family partnership to deal with all the issues involved trying to keep the policy proceeds out of both spouses’ estates.

B. Current Insurance Cost. Table 2001 ( ¶ 11.2.02 ) covers only single life policies. Notice 2002-8 provides that “Taxpayers should make appropriate adjustments” to the Table 2001