The participant will be taxed on the current insurance benefit if the plan employs deductible employer contributions to pay the insurance premiums. The P.S. 58 cost refers to the taxable element of the purchase price.
How are PS 58 costs calculated?
To offer death benefits, a qualified retirement plan may obtain life insurance. The plan agreement must authorize such a purchase, however the choice to acquire a policy can be made by the plan administrator (employer) or the member. The policy is part of the participant’s account in a Defined Contribution plan. The death benefit in a Defined Benefit plan is part of the plan’s clearly determinable benefit to the participant.
INCIDENTAL BENEFIT
The purchase of life insurance must be a byproduct of the plan’s primary goal of providing retirement benefits. As a result of this incidental advantage, treasury regulations impose the following limits on the amount of premiums paid:
- Whole life – the total premium cost is less than 50% of all contributions (401(k), employer match, employer profit sharing, and forfeitures, but not investment returns).
- Term or universal life insurance has a total premium cost of less than 25% of total contributions.
Life insurance premiums can be paid with contributions that have been in the plan for at least two years. After-tax employee contributions and rollover contributions are not subject to the incidental restrictions and can be used to pay premiums.
The 100x rule, which states that insurance payments are considered incidental if the face value is no more than 100 times the plan’s projected monthly annuity benefit, is commonly used in Defined Benefit Pension plans. As a result, the majority, if not all, of the plan’s participants must have insurance plans.
TAXABLE PORTION OF PREMIUM P.S. 58
The insured plan participant must accept the life insurance protection component of the premium as a taxable benefit each year. This is referred to as a P.S. 58 cost. The IRS has a table (Table 2001) that explains how to figure out how much insurance protection you need at a certain age. The following is the formula: The table factor is $1,000 divided by the face amount less the cash value. Instead, the insurer’s advertised rates can be used, although plans produced after 2003 should be approached with caution. Unless the participant is a Self-Employed Individual, the P.S. 58 charges are deducted from the participant’s account and are not taxed again when disbursed to the participant or beneficiary.
DEATH BENEFIT PAYMENTS
The life insurance policy’s death benefits are deemed “net proceeds” and are not included in gross income. The face amount of the policy less the cash value plus the accrued P.S. 58 charges equals the net insurance proceeds. A policy with a $300,000 death benefit, $60,000 in cash value, and $10,000 in cumulative P.S. 58, for example, would provide a tax-free benefit to the beneficiary of $250,000.
As part of the participant’s total benefit, death benefits are paid to the plan trustee and distributed to the beneficiary.
POLICY DISTRIBUTION OPTIONS
If a participant with a life insurance policy held by the plan separates from service, he or she has numerous options.
- Take personal responsibility for the policies. Ownership of the plan is transferred to the participant. This option requires the participant to either
- Pay the plan the policy’s fair market value (cash value plus any “reserves”).
- As a taxable distribution, take the cash value. The federal income tax withholding rate is 20% under this option, therefore a portion of the account would have to be redeemed to meet the tax.
- Switch to a new employer’s plan. The member could request a transfer of their insurance policy to their new employer’s plan if the receiving plan allows it.
- Give up the policy. The insurance funds will be included in the participant’s distribution if the plan trustees surrender the contract. For tax reasons, the P.S. 58 costs retain their status as a basis.
- Convert to a monthly annuity. If a dispersed life insurance policy is converted to a non-transferable annuity contract within 60 days of the insured’s death, the fair market value of the contract can be used to avoid paying income tax.
PROS
- Some employees may be able to only afford insurance if they have the choice to purchase it with plan assets.
- In the event of a premature death, life insurance will cover the participant’s family.
- Even for people who would be uninsurable on the free market, guaranteed-issue policies may be offered.
- Transferring the policy out of the plan to continue to benefit from the tax-deferred growth of cash value.
CONS
- Some claim that life insurance is a tax-deferred vehicle by definition, and that it doesn’t need to be offered under a tax-deferred qualifying plan.
- Each year, P.S. 58 costs are taxed, putting extra pressure on the plan sponsor to properly record and track them.
- Because the rate of return on a life insurance policy differs from that of other investments, including insurance in the plan may diminish the participant’s overall retirement payout.
SUMMARY
Allowing life insurance to be acquired through a qualified retirement plan may be beneficial in some situations. Offering this benefit as part of the plan necessitates additional administration by a company familiar with the items. We have extensive expertise working with insurance in qualifying plans at Benefit Resources, Inc., and we take the required steps to advise our clients who choose this choice. On the participant statements, we report the cash value. We calculate, track, and report P.S. 58 expenses, and we provide policy disposition choices at termination or retirement.
What is PS 58 table?
If dividends are used to purchase paid up additions and the employer is entitled to the cash surrender value and the employee’s beneficiary receives the balance of any death benefit, the cost of Table 2001 (P.S. 58), or the yearly renewable term cost if lower, is reportable.
What happens when life insurance is part of a qualified plan?
The premium is paid using pretax cash when life insurance is acquired in a qualifying account. As a result, the member must report the monetary advantage as taxable income.
What is the difference between qualified and non qualified?
The biggest difference between the two programs is how employers treat deductions for tax purposes, but there are other distinctions as well. Employee contributions to qualified plans are tax-deferred, and employers can deduct money they contribute to the plan. Nonqualified plans are funded with after-tax monies, and employers cannot deduct their contributions in most situations.
Can you roll life insurance into a 401k?
You can choose from a number of 401(k) rollover reinvestment choices. You can alternatively keep the money in your existing 401(k) or move it to a new company’s plan. However, if you transfer your qualifying assets to an IRA, annuity, or life insurance policy, your new account will be free of the restrictions and rules imposed by your old employer’s program. You will have more control over how and where you invest your money as a result of this.
Working retired members of SCRS or PORS
If you are a working retired member of SCRS or PORS and your employer participates in incidental death benefit coverage, your beneficiary will receive a payment equal to your current annual earnable remuneration if you die while on active duty. Because the amounts given to your beneficiary are considered taxable benefits, federal taxes will be withheld unless your beneficiary transfers the funds to another qualified retirement plan. Your beneficiary has the option of having state taxes deducted from the payment.
Non-working retired members
If you die as a non-working retiree and your last employer before retirement provides incidental death benefit coverage, your beneficiary will receive a payment depending on the retirement system from which you retired and your service credit. Because the amounts given to your beneficiary are considered taxable benefits, federal taxes will be withheld unless your beneficiary transfers the funds to another qualified retirement plan. Your beneficiary has the option of having state taxes deducted from the payment.
How is split dollar life insurance taxed?
Over the last four decades, so-called “split-dollar” life insurance arrangements, in which two or more parties share the expenses and benefits of a life insurance policy, have become increasingly prevalent. The popularity of these arrangements has been fueled by favorable tax treatment. Changes in the taxation of split-dollar plans were recently revealed by the IRS, and these changes cast doubt on the future utility of some of these arrangements while also posing a risk of potentially disastrous tax repercussions for participants in certain existing split-dollar plans.
Many split-dollar techniques that were created previous to the IRS’s change of heart will simply not work.
Individuals and businesses who are currently parties to a split-dollar life insurance contract should have it examined as soon as possible to see how the changes will effect their contract.
For some, the new tax laws will have very minimal ramifications, but for others, the split-dollar agreement should be discontinued or at least substantially adjusted possibly before January 1, 2004, the IRS’s deadline for terminating or modifying some programs without unfavorable tax consequences.
BACKGROUND
Today, there are several different types of split-dollar plans, all of which involve two or more people or corporations splitting the costs and benefits of permanent life insurance. A split-dollar “policy” is not an insurance policy; rather, it is a contract between the parties that spells out their responsibilities for splitting the costs and their rights to a share of the insurance proceeds. An insured person may engage into an agreement with family members or a trust for the benefit of the family, but the majority of split-dollar plans involve a fringe benefit program in which an employer aids an employee in acquiring a life insurance policy for the benefit of the employee’s family. These employment-related split-dollar contracts were sometimes utilized as a form of deferred pay and sometimes as a way for the insured employee to prepare his or her estate.
Split-dollar life insurance plans, unlike many other fringe benefit programs, are not based on legislation or judicial law.
Instead, the IRS issued a Revenue Ruling in 1964 that largely regulated the tax effects of split-dollar life insurance products.
1
Despite the fact that a Revenue Ruling is a very weak legal authority, split-dollar insurance has become such a popular notion that almost every business has implemented some form of split-dollar insurance for one or more of its employees.
In a split-dollar agreement, the employer pays all or most of the policy premiums in exchange for a share of the cash value and death benefit. Previously, the IRS held that the “term cost” of life insurance protection must be recognized as income by the insured employee. “Term cost” simply refers to the cost of a one-year term policy on the covered employee with the same death benefit, i.e., how much it would cost the employee to purchase the same amount of insurance protection for a year under a term policy. 2 In some cases, the employee is responsible for the term costs. Term expenses are often modest until a person reaches a certain age, and they are typically far lower than the actual premiums paid on the policy.
Assume a 40-year-old male employee signed a split-dollar agreement with his company before January 28, 2002, in which the employer pays all premiums, and the employer paid a $10,000 premium on a $1,000,000 life insurance policy guaranteeing the employee’s life in 2004.
The cheapest premium for a $1,000,000 term insurance policy covering a 40-year-old male, according to the insurance firm issuing the policy, is $200.
Even though the business paid $10,000 in premiums, the employee would have to declare $200 in taxable income on his 2004 personal income tax return as a result of the split-dollar agreement.
When a split-dollar plan is part of an employee’s estate plan, the insured employee will often create an irrevocable life insurance trust (ILIT) to hold the split-dollar plan’s policy.
If done correctly, the life insurance proceeds are removed from the employee’s gross estate for estate tax purposes.
When an ILIT has a life insurance policy, the employee is regarded to have given a taxable gift to the ILIT in the amount of the policy’s term cost (the same amount taxed to the employee).
Split-dollar agreements have been popular since they rely on term costs to value the taxable income to the employee (and the gift to the ILIT).
In effect, the employee receives the benefits of a permanent life insurance policy for a fraction of the cost of a low-cost term coverage.
The term cost of a policy, however, ceases to be a bargain at some point in the employee’s life, and some form of exit strategy has always been an important aspect of split-dollar life insurance planning.
Consider the price of a $5 million term life insurance policy on an 85-year-old man.
(Even if the employer no longer has to send a check to the insurance carrier because the policy has enough value to carry itself, the IRS has always held that the term cost is deemed income to the insured employee as long as the plan exists.)
Without an exit strategy, an employee who lived to a ripe old age and was insured with a sizable split-dollar policy would be forced to recognize tens of thousands of dollars in phantom income each year and, if an ILIT was involved, suffer the implications of making huge phantom taxable gifts.
Split-dollar agreements resemble interest-free loans in appearance.
The IRS, on the other hand, stated in the 1964 Revenue Ruling that split-dollar transactions would be regarded a taxable fringe benefit to the employee rather than an interest-free loan by the IRS.
As a result, an employee might give considerable benefits for his or her family for a very modest income and gift tax consequence by taking advantage of the employer’s generosity.
RECENT CHANGES
Despite widespread acceptance, the IRS has always been able to change its approach to the taxation of split-dollar arrangements simply by issuing new Rulings due to a lack of statutory and legal basis. The IRS has indicated in recent years that it is reconsidering the tax treatment of split-dollar agreements, particularly the sort of split-dollar structure known as “Split-dollar equity.” The employer is only repaid for premiums paid from proceeds or cash value under an equity split-dollar arrangement. The policy’s cash surrender value finally surpasses the employer’s reimbursement right, and this difference is referred to as the policy’s excess value “Equity in policy.” Because the IRS viewed policy equity to be a benefit offered to an employee, the IRS was upset that it dodged income taxation. The IRS, on the other hand, struggled to come up with a legal basis to justify taxing this equity.
The IRS issued split-dollar arrangement notices in 2001 and 2002, each with updated explanations of how the IRS intended to tax split-dollar arrangements.
The IRS’s intention to publish new regulations codifying a comprehensive approach to the taxation of split-dollar life insurance based on two mutually exclusive tax regimes was announced in the second of these notices, Notice 2002-8 (which revoked the 2001 Notice), which was issued on January 28, 2002.
Proposed regulations were released in late 2002, however the final version has yet to be released. Unfortunately, much of the widely recognized taxation theory on which most existing split-dollar plans are built is in disagreement with the methodologies stated in the Notice and proposed regulations.
All new arrangements will come under one of two split-dollar taxation regimes, according to the draft regulations, whenever the final regulations are implemented.
Which regime will apply to a certain arrangement will be determined by who owns the policy (an almost insignificant issue in the prior system).
If the policy is owned by the employer (or another person responsible for paying the premiums), the arrangement will be taxed “Analysis of economic benefits.”
The arrangement will be taxed as a business if the employee owns the policy “A dollar-for-dollar loan.”
With the key caveat that under equity arrangements subject to the economic benefit analysis, policy equity will be taxable income to the employee, the economic benefit analysis substantially parallels the previous approach to split-dollar taxes.
All premiums paid by the employer will be classified as a loan to the employee under the split-dollar loan treatment.
If the loan does not have an acceptable rate of interest (as established by the laws), the regulations establish a complicated system of presumed interest that flows from the employee as revenue to the employer as interest.
Regrettably, the tax implications of current agreements are less obvious.
Policy equity will be taxed as it accrues under the proposed regulations unless the premiums are classified as a loan.
It is also clear that policy equity will not be taxed for current plans as long as the agreement is in effect.
What is unclear is how an existing plan’s equity will be taxed if the plan is terminated during the employee’s lifetime.
If the employee dies while the agreement is in effect, the policy equity may be tax-free, but for many split-dollar participants, this is a small consolation because most equity plans were designed to be terminated when the policy had built up enough cash value to repay the employer while still retaining enough value to carry itself without further contributions from the employee.
The income (and presumably gift) tax ramifications of soaring term costs as the insured grew older were avoided by terminating the split-dollar plan before death.
Given the ever-increasing term costs, continuing the split-dollar plan for the rest of the employee’s life is just not a practical choice in most cases.
If the IRS pursues taxation policy equity when current plans are terminated, the tax consequences could be shocking.
For example, if a life insurance policy subject to an employment-related split-dollar agreement has $5,000,000 in cash value at the time of rollout, and the employer is entitled to a return of $1,500,000 for premiums paid, the employee must recognize $3,500,000 in additional taxable income that year.
If the insurance was owned by an ILIT, the employee would be judged to have made a taxable gift of $3,500,000 to the ILIT that year.
Furthermore, there would be a $3,500,000 generation-skipping transfer (GST) subject to the GST tax if the ILIT was meant to provide for grandchildren and future generations.
To make matters worse, if the policy was owned by the ILIT, the employee would be unable to pay the tax due to the termination of the split-dollar arrangement.
For equity split-dollar plans established on or before January 28, 2002, and not modified after that date, there are two safe harbor requirements.
The first safe harbor stipulates that policy equity will not be taxed if the arrangement is terminated before January 1, 2004. The second safe harbor allows equity agreement participants to switch to loan treatment prior to January 1, 2004, with no taxation on policy equity.
These safe harbors may provide a realistic solution for split-dollar participants in specific situations.
In other circumstances, however, the parties may need to rethink their strategy in order to attain their initial objectives.
Some commercial lenders are starting to offer life insurance purchase financing that will allow participants to avoid split-dollar agreements entirely.
SPECIAL PROBLEM FOR PUBLIC COMPANIES
There is another difficulty that management must deal with in publicly traded organizations. On or after July 30, 2002, it is prohibited for a publicly traded business to loan monies to officers, directors, and certain other senior personnel under the terms of the Sarbanes-Oxley Act. Although there are signs that split-dollar arrangements are likely subject to the Sarbanes-Oxley Act’s restrictions, the Department of Labor, which has jurisdiction over this matter, has not directly addressed this question. As a result, most publicly traded firms have taken the stance that on or after July 30, 2002, no payments on a split-dollar contract insuring the life of any of their employees covered by the Sarbanes-Oxley Act can be made. Because the final stance of the Department of Labor has not yet been announced, these split-dollar arrangements for publicly traded corporations have not been canceled. Publicly traded firms’ split-dollar plans, on the other hand, are subject to the same income, gift, and generation-skipping tax issues as non-publicly traded companies’ split-dollar plans. If the employer wants to take advantage of the safe harbor rules, management must resolve the tax issues (possibly without the benefit of Final Regulations) and the Sarbanes-Oxley Act issues (possibly without a final position from the Department of Labor), and make these decisions before January 1, 2004.
REVIEWING EXISTING ARRANGEMENTS IS VITALLY IMPORTANT
Because the safe harbor provisions are set to expire on January 1, 2004, and because all subsequent split-dollar arrangements must choose between compensation and interest-bearing loan treatment, every split-dollar arrangement should be examined as soon as practicable. Many of the tax advantages that split-dollar arrangements once provided are vanishing, and finding adequate alternatives will necessitate careful and imaginative planning. Split-dollar arrangements, which were once a simple and uncomplicated world, have now evolved into a complex and frustrating collection of difficulties that all parties involved should address as soon as possible.
What is a qualified retirement plan?
A qualified retirement plan is a plan created by an employer that is designed to provide retirement income to selected employees and their beneficiaries and that complies with specific IRS Code standards in terms of both form and operation. 401(k) plans, pension plans, and profit-sharing plans are all common plan types. Both company and employee contributions may be allowed in a qualified retirement plan. Employers must adhere to protocols in order to ensure that participants and beneficiaries receive their benefits. Changes in retirement plan legislation and regulations must also be kept up to date. Employers can benefit from qualified retirement plans, and employees who contribute can benefit from tax deferral. Taxes on gains from contributions are likewise postponed until the employee takes the money out of the plan.
ERISA, or the Employee Retirement Income Security Act of 1974, is a federal law that governs qualified retirement plans. ERISA serves to protect U.S. employees’ retirement money in private sector and establishes minimum plan criteria.
Should I pay for life insurance before or after tax?
Buying life insurance, unlike buying a car or a television, does not involve the payment of sales tax. This implies that the premium amount provided to you when you apply for coverage is the amount you pay, with no percentage amount added to cover taxes. With that said, a policyholder may be obliged to pay taxes on insurance premiums in certain circumstances.