Whenever life insurance is proposed the first two client-questions that inevitably follow are: first, how much will it cost and then, are the premiums deductible (especially if the client is a business-person). Let’s deal with the second.
In a business situation life insurance premiums are never deductible. Even in an executive bonus arrangement the employer can write off amounts paid only because, in fact, the amounts are W-2 compensation, not because they are eventually spent on life insurance.
In the personal context there hovers about the discussion of tax-deductible costs for coverage the possibility of holding life insurance in a qualified plan.
It sounds good at first blush. Contribute to the plan and use the untaxed dollars to buy a policy. But take a closer look.
Permanent insurance outside a plan can be broken down into three parts.
On the bottom is basis, the after-tax dollars used to pay premiums (it can be a little more complicated than that, but let’s keep in simple). Above that is the potentially taxable, but currently tax-deferred gain in the policy, i.e. the reserves in excess of the basis. On top is the risk portion, the amount of death benefit over the policy values.
Two tax advantages to keep in mind with non-plan coverage are:
- So long as the policy stays in force prior to death, the gain in the policy can be protected from taxation
- In the event of death the whole kit and caboodle (basis, gain and risk) is paid to the beneficiary income tax-free
Now compare to the taxation of a policy in a qualified plan.
Untaxed dollars inside the plan are used to buy the life insurance. So far so good. But next the plan administrator must report each year as taxable income to the insured plan participant the “economic benefit” realized by the coverage. This is often calculated using the carrier’s one-year term rates acceptable to the IRS.
The result is an amount usually lower than the actual premiums paid. On balance the participant comes out ahead, but not with as much sizzle as they may have anticipated.
What will follow from there is one of two unavoidable tax disadvantages that are avoided with insurance outside the plan.
If the participant retires or otherwise separates from service most plans do not allow the policy to remain in the plan. If the policy is distributed its FMV (usually the account value) must be recognized to the extent of the FMV exceeds the accumulated economic benefits recognized over the years of participation, i.e. the gain is taxed, a result that would not have happened with coverage outside the plan. The participant can buy the policy out of the plan, but the result is the same. The heretofore untaxed gain in the contract is not purchased with after-tax dollars.
If the participant dies while the policy is in the plan the beneficiary receives the death benefit tax-free only to the extent that it exceeds the policy value minus the accumulated economic benefits. Again, the gain in the policy is taxed, unlike when a death benefit is received for coverage outside the plan.
There will always be taxation of the policy gain. In addition, if the insured anticipates death tax liability, either federal or state or both, the proceeds from a plan-owned policy cannot be kept out of the taxable estate. Both are things to consider before hastily buying coverage inside a qualified plan with the hope of, at least, part of its cost being paid for with untaxed dollars.
Call with any question concerning coverage inside or outside a plan.
Tom Virker, JD
Director of Advanced Markets