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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
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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.

08 Apr

Use Life Insurance and a Rabbi Trust To “Fund” Your Nonqualified Deferred Compensation Plan

Estate Planner Mar-Apr 1998
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Companies use nonqualified deferred compensation plans to compensate key employees over and above the employees’ base salaries. Because employers cannot set aside money protected from creditors to fund nonqualified plans without incurring current tax liability for the employees, they often use life insurance and rabbi trusts as funding mechanisms to meet both the employees’ needs and their own.

How Nonqualified Plans Benefit Employers 

Nonqualified plans benefit employers by offering the employees an incentive to stay with the company over a period of years, often through a vesting mechanism. For example, a plan might provide that an employee will receive a certain amount of compensation on termination of employment, but that only a portion of that compensation will vest each year over the next 10 years. Thus, to receive the entire amount of deferred compensation, the employee must remain with the company for 10 years.

In addition, with a properly structured nonqualified plan, the company can avoid the highly complex and burdensome rules that cover qualified plans. These include rules on participation, coverage, discrimination and reporting.

How Nonqualified Plans Benefit Employees 

Nonqualified plans benefit key employees by allowing them to defer tax on compensation that they will receive in later years, when their effective tax rate may be lower. Under a typical nonqualified plan, amounts are deferred while the employee works for the company and are paid later when the employee retires, becomes disabled or dies. The goal is to structure the plan so that the employee is not taxed on those amounts until one of these events occurs and the employee is actually paid.

To ensure that the employee is not subject to current tax on the amounts payable under the nonqualified plan, the plan cannot be funded. This does not mean that a company cannot set aside funds to satisfy its future obligations. What it does mean is that any amounts a company sets aside to ultimately pay the deferred compensation must be subject to the claims of the company’s general creditors. Otherwise, the employee is treated as having received the compensation and is currently taxed on those amounts.

Life Insurance Provides Indirect Funding Mechanism

Life insurance is a popular funding mechanism for a nonqualified plan. Typically, an employer purchases insurance on the life of an employee. The company then owns the policy and also is named its beneficiary, but does not receive a deduction for premium payments on the policy. To avoid being taxed on the value of the contract, the employee generally does not receive any interest in the policy. The employee cannot name a beneficiary to receive life insurance proceeds on his or her death, but can name a beneficiary of the nonqualified plan, such as his or her spouse, to receive the then-vested amounts of deferred compensation.

Any insurance proceeds paid to a company on an employee’s death generally are on an income-tax-free basis, though they may be subject to alternative minimum tax. If the employee retires or becomes disabled and is entitled to amounts under the nonqualified plan, the company can relinquish the policy and use the cash value to pay the deferred compensation. This may, however, result in current taxable income to the company, but only to the extent of the gain.

The Rabbi Trust Offers Preservation and Protection

A rabbi trust is a type of nonqualified plan in which funds are segregated into an irrevocable trust. The trust helps preserve funds an employer might otherwise spend and offers an employee some measure of comfort that money will be available when the deferred amounts become payable to him or her.

More important from an employee’s perspective, a rabbi trust allows a company to irrevocably segregate funds that it can use to pay the compensation in the future. Although these funds are subject to the claims of the company’s general creditors, they remain in the trustee’s control if the company changes hands. Despite the fact that funds are segregated, the rabbi trust is not deemed to be a funded plan.

Life Insurance and Rabbi Trust in Tandem

A company can use life insurance in tandem with a rabbi trust by making contributions to the trust to fund the premiums. The trust then uses those funds to purchase insurance on the employee’s life. The trustee is both the owner and beneficiary of the policy.

To avoid current taxation, neither the employee nor his or her beneficiary can have an interest in the insurance or the trust assets. The employee (or his or her beneficiary) will only have rights to amounts held by the trust equal to those of an unsecured creditor. If the nonqualified plan meets these and certain other requirements, it will be considered unsecured and unfunded, and income tax to the employee will be deferred.

Benefits for Employer and Employee Alike

A nonqualified plan can effectively help an employer secure the continued services of a key employee. By purchasing life insurance through a rabbi trust, the company can enjoy a tax-advantaged investment vehicle while giving the employee some peace of mind that funds will be available to pay the deferred compensation. To learn more about these options, please call us. We can help you choose one that meets your needs.

 

Insurance Benefits for Companies With Nonqualified Plans

Used to fund a nonqualified plan, life insurance provides several benefits:

  • A company can receive a market rate of return on the investment in the policy while using it as a tax-deferred investment vehicle.
  • If an insured employee dies early in the term of the nonqualified plan, funds will be available to the company through the payment of the death benefit, which the company can then use to pay the employee’s beneficiary under the plan.
  • With a combination of loans and withdrawals against its cash value, the company can achieve tax-free distributions from the policy.