A smart use of retirement funds

If you have more than you need in your retirement plan, buying life insurance with the excess can generate significant tax savings.

Mark T. Watson & David P. Zaudtke

Business owners often have a substantial amount of wealth invested in a variety of retirement plans. The balances in these qualified plans may be more than the owner needs during retirement, and he or she may also have other assets such as stocks that are sufficient to cover retirement needs. Owners in this position usually assume that the unused balances in their plans will be available after they die to support a surviving spouse or children.

Not so. Unfortunately, the remainder of retirement plans at an owner’s death are subject to substantial taxes, even an “excess accumulation excise tax”—an extra 15 percent estate tax imposed on large qualified plan balances. Together, these taxes can reduce the remaining assets in qualified plans by 80 to 90 percent—leaving survivors almost nothing.

Purchasing life insurance with retirement plan assets can greatly reduce this exposure. The tax savings can be achieved by requesting or taking required distributions from the retirement plans and using the after-tax proceeds to purchase life insurance. Or the owner can set up a “subtrust,” a new vehicle as yet unchallenged by the IRS, that may allow insurance to be purchased with tax-deductible dollars.


Excess accumulation

Of course, it is wiser to save too much than too little for retirement. Most owners use “qualified” retirement plans to fund some or all of their retirement savings with pre-tax dollars; qualified retirement plans include pensions, employee profit-sharing plans, and IRAs (and Keoghs for self-employed people). But balances left in qualified plans after the owner’s death will be subject to estate, generation-skipping, and income taxes. In addition, large balances will be subject to the excess accumulation excise tax; the IRS definition of “large” is linked to the owner’s age and interest rates in effect at death, but as a general rule balances of $1 million or more will be taxed.

A simple way to avoid many of these taxes is to take annual distributions from the qualified plan and use them to fund an irrevocable life insurance trust that will purchase insurance on the owner’s life. Although the owner will be subject to income tax on the distributions, this procedure will provide the following benefits:

• Reduction or elimination of excess accumulation excise tax.

• Exclusion of all life insurance proceeds received by the trust from the owner’s gross estate for estate tax purposes.

• Avoidance of income tax on the entire amount of insurance proceeds received by the trust.

Thus, by accelerating retirement plan distributions, the owner can substantially reduce the tax burden on a surviving spouse and heirs—while also providing a life insurance policy for them.


Setting up a subtrust

These benefits may be extended even further with a subtrust, though at this time it is unclear how much of the added benefits the IRS will recognize.

A subtrust is essentially an irrevocable life insurance trust established as part of an employer-sponsored qualified retirement plan. The plan is typically divided into two parts: the subtrust, which holds life insurance policies on the participant, and the main trust, which holds all of the participant’s other assets in the plan.

Death benefits are paid exclusively from the subtrust. The trustees of the subtrust and main trust are different people, who have jurisdiction only over their part of the plan. The plan administrator and employer have no authority over the assets, liabilities, or administration of the subtrust. The subtrust plan provides that in no event will it be possible for benefits to be paid from the subtrust to the owner, his or her estate, or his or her creditors, a necessary condition to exempt the proceeds from estate taxes.

Like the straight purchase of insurance described above, the subtrust option reduces or eliminates the excess accumulation excise tax, and may exclude all life insurance proceeds received by the trust from the owner’s gross estate for estate tax purposes. It also avoids income tax on the death benefit portion of the insurance policy. The unique feature—and added benefit over a straight purchase—is that it allows the participant to purchase the life insurance with pre-tax dollars. This is so because the contributions to the qualified plan, which are tax-deferred, are used to pay the life insurance premiums.

Great care must be taken when establishing a subtrust to avoid violating any of the qualified plan rules. And while attractive, subtrusts carry a risk because their tax-exempt benefits have been untested by the IRS. For example, it is uncertain whether the life insurance held by the subtrust may actually be excluded from the owner’s gross estate for estate tax purposes.

There are a few other caveats to consider. When insurance is purchased through what is primarily a retirement plan (such as a pension or profit-sharing plan), generally no more than 25 percent of the contributions to the plan can be used to purchase life insurance. For self-employed people who have Keogh plans, there are minor technical differences in how a straight purchase or subtrust is set up, but in the end the limits and benefits are basically the same.

Purchasing insurance with retirement assets using either method can generate significant tax savings, and thus provide additional wealth to an owner’s surviving spouse or heirs. To achieve the savings, fairly complex income, gift, and estate tax rules must be followed. Nevertheless, for owners who have more than enough assets in their qualified plans, or outside sources of income, to meet their retirement needs, it makes little sense to have the surplus savings wiped out by excessive taxes. The benefits to your survivors are well worth the complexities involved in the planning.


Mark T. Watson is a managing director at KPMG Peak Marwick in Dallas, and a director of the company’s Family Wealth Institute. David P. Zaudtke is a partner in KPMG’s Minneapolis office and a director of the Family Wealth Institute.