Preretirement Death Benefits

Learn the rules, including taxation, so you can help business-owner clients with this planning technique.

By Kirk Okumura

Qualified plans are designed primarily to provide retirement benefits and defer compensation. However, employers can use life insurance within a qualified plan to offer incidental preretirement death benefits to their employees.

This may be appealing if business owners and executives:

• want to shift a nondeductible personal expense to the company
• have life insurance needs not met by group or personal insurance plans
• want to maximize their preretirement death benefit

Before stepping into this arena, however, you need to know the rules governing the inclusion of life insurance in qualified plans, including the taxation of the premiums.

The rules
By law, the insurance coverage must be based on nondiscriminatory factors and the death benefits must be incidental. The insurance is considered incidental if either of the following tests, simplified for this article, is met.

The first test is actually two separate tests, one for term and universal life policies and the other for whole life policies. For term and UL policies, the death benefit is incidental if the aggregate premiums are less than 25 percent of the aggregate contributions for any participant. Only the cost associated with the pure insurance portion of a UL premium is used in this calculation. For whole life policies, the benefit is incidental if the aggregate premiums are less than 50 percent of the aggregate contributions for any participant.

The second test, the 100-to-1-ratio test, provides that life insurance is considered incidental to a qualified plan in which the death benefit does not exceed 100 times the expected monthly benefit.

Traditionally, the first test has been used by defined-contribution plans and the second by defined-benefit plans. However, any type of plan can use either test.

Taxation of pure insurance
When a qualified plan purchases life insurance on the lives and for the benefit of its participants, the employer can deduct its share of the contributions.

For the employee, the beneficiary receives the pure insurance portion (the death benefit less any cash value) of the preretirement death benefit income-tax-free. Unfortunately, the IRS deems the pure insurance portion of the preretirement death benefit to be a current benefit. Consequently, the amount of any contributions used to pay the insurance premiums for the pure insurance portion is currently taxable to the employee.

For term insurance, the full premium is generally taxable. However, the cost associated with the first $50,000 of term insurance may be tax-free under IRC Section 79 if group term insurance is used. For permanent insurance, the taxable amount is found by multiplying the rate for one-year term insurance at the participant’s attained age by the difference between the face amount of the policy and the cash value of the policy at year-end.

The IRS furnishes a table of one-year term rates to determine the taxable portion of the premiums. Until the 2002 tax year, the PS 58 table was used. It is due to be replaced; until then, the IRS has published an interim table known as Table 2001 (also used with split-dollar plans). A company’s published one-year term rates may be substituted for Table 2001 rates as long as the rates are published and are available to all standard risks.

Because the Table 2001 and/or PS 58 costs associated with permanent insurance are taxable, they are considered part of the employee’s cost basis in the benefits the policy provides, and so are recoverable without further taxation. The recovery of cost basis applies only to distributions from the policy’s cash value (See box).

For more information on this subject, take LUTC course 252: Essentials of Employee Benefits.

Kirk Okumura is an LUTC author and editor. Contact him at Kirk.Okumura@The American College.edu.