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08 Apr

When Life Insurance May Be Better Than a Qualified Retirement Plan

In Insurance,Retirements by admin / April 8, 2013 / 0 Comments

Estate Planner Mar-Apr 1998

Pension and profit-sharing plans are a means to set aside funds for retirement. Congress has provided tax benefits to qualified pension and profit-sharing plans in an effort to encourage employers to provide retirement benefits to employees and to encourage the self-employed to save for their own retirement.

Because qualified plans must meet strict requirements, they may prove too burdensome for some employers. Many employers are looking for alternative ways to provide retirement benefits for themselves and key employees that will come close to the benefits of qualified plans.

One alternative is life insurance. Life insurance can have some of the same general benefits as qualified plans. To understand why, you need to know not only the differences between qualified and nonqualified plans, but also some of the tax characteristics of a life insurance policy. First let’s discuss what it means to be qualified.

Qualified for What?

One of the general principles of income taxation is that an employer can take a deduction for wages paid only when the employee is required to report the wages as income. Usually, this is when the wages are paid. Deferred compensation, which generally includes retirement and pension payments, is compensation received in a later year than when earned and currently is not deductible by the employer. However, qualified deferred compensation provides two important benefits:

1. The employer may deduct the compensation when it is, in fact, set aside for the employee, but the employee does not report the compensation as income until he or she actually receives it. This is one of the few areas where the Internal Revenue Code (IRC) sanctions a mismatch of deduction and inclusion.

2. The compensation that is set aside for the employee can earn and accumulate income tax-free until the employee receives it.

Qualified deferred compensation must be part of a plan and can take different forms:

  • Defined benefit plans. What employees receive at retirement is a percentage of salary earned while they worked.
  • Defined contribution plans. Employers put a certain dollar amount into the plan and the kind of retirement benefit employees receive depends on the investment performance of their accounts. Section 401(k) plans and individual retirement accounts (IRAs) are forms of defined contribution plans. 

All qualified plans require employers to put funds aside now so that employees can get at them later.

Stringent, Formal Requirements 

Most important, qualified plans cannot discriminate in favor of the highly compensated. Also, the participating employee’s benefit must become nonforfeitable (vested) within a short period of time (gradually from three to seven years or all at once after five years — shorter if the plan predominately benefits the highly compensated). Further, the plan must benefit a large percentage of the company’s employees.

For pension plans, there also are funding requirements. For example, employers must do more than make a promise to pay; they must put the appropriate amount into the plan each year. In considering whether a plan favors the highly compensated, compensation in excess of $150,000 must be ignored, thereby causing certain highly compensated individuals to receive benefits based on a lesser percentage of their salaries than the rank and file employees.

Why Avoid a Qualified Plan?

One of the reasons for looking for a substitute for retirement planning is to avoid the requirements necessary to be qualified. Why? You may want a plan solely for officers of the employer. By definition, a plan for officers will favor the highly compensated. Such a plan also will fail to satisfy minimum participation standards for a qualified plan because fewer than 70% of employees participate in the plan.

Life Insurance Plan Advantages

If you want a retirement plan to benefit only highly compensated or stock-owning employees, or others with a financial interest in the business, you have to use a nonqualified plan. Life insurance has several tax advantages that make providing retirement benefits desirable.

For instance, earnings in the insurance policy accumulate tax-free. Also, the owner of the policy (usually the insured) can borrow against the cash value in the policy without tax consequences if the policy comes within the IRC definition of life insurance. Generally, to fit the definition of life insurance, the policy must have premiums scheduled over a period of at least seven years. The employee must pay interest on the borrowed sum, and the interest rate often is close to the dividend rate being earned by the cash values in the policy.

Having a policy with a premium pay-in period of seven or more years, by itself, is not unusual and does not need an employer to implement it. The employee may make seven or eight scheduled annual premium payments using funds from his or her own pocket. Often, the source of the premium is an annual employer-paid bonus that is deductible to the employer as compensation paid and taxable to the employee as income. Depending on the type of insurance product used for the nonqualified plan, the scheduled premium payments can be tailored to the employee’s current financial situation and future objectives.

If an employer wants to further benefit the employee, it can contribute unscheduled premium payments (nondeductible), retaining the right to receive these payments back without interest at a later date. In essence, the employer can agree to a split-dollar insurance arrangement — the employer is making a tax-free loan to the employee’s policy.

The type of insurance policy used for a nonqualified plan often is a second-to-die (husband and wife) whole-life product that is interest-sensitive and designed for greater cash value accumulation. The nonqualified plan can continue for as long as the employee desires.

A Few Important Life Insurance Questions

Q: What happens when the employee retires?

A: Up to a certain point, the employee borrows cash value from the policy and never has to report the loan proceeds as taxable income. However, some cash value must stay in the policy to support a death benefit.

Q: How good is the rate of return on insurance policies?

A: That depends on interest rates and the insurance company’s investment performance, but the unscheduled premium payment from the employer should provide additional accumulation for the employee. Your insurance advisor can provide an illustration at various interest rates. Look at a minimum at the strength of the company, the current rate the company is offering and its lowest guaranteed rate.

Q: Is an insurance pension plan right for all employees?

A: Of course not. Different alternatives are right for different people. Further, all of the tax consequences of an insurance pension plan need to be confirmed. The only way to know whether this kind of plan fits your needs is to explore the benefits, risks and costs. It may be a better alternative than a qualified retirement plan.

Insurance as Retirement Plan Substitute Can Make Sense

Under current tax laws, it will be difficult for a highly compensated employee or owner-employee to accumulate significant assets for retirement under a qualified plan. Using a private retirement plan funded with insurance as a substitute for or in addition to a qualified plan may offer retirement benefits sufficient to maintain an employee’s standard of living while providing greater flexibility in creating a program that meets the needs of both employer and employee.

Please contact us with any questions you may have about insurance pension plans or other retirement planning vehicles. We would welcome the opportunity to help you meet your business’s needs and your employees achieve their retirement goals.