Tax Implications of Using Pension Maximization

Survivor benefit distributions from a qualified plan and from a life insurance settlement option share some tax features, but differ in at least one important respect. In either case, income taxation on investment earnings is deferred until distributions are received. However, the distributions from a qualified plan will generally be subject to tax in their entirety, unless the participant acquired some nontaxable basis in the plan (for example, through nondeductible contributions, Table 2001 costs (formerly P.S. 58 costs) for insurance, or for loans that were treated as distributions and then repaid).

Life insurance death proceeds are generally paid free of income tax. Consequently, if the death benefits are essentially used to purchase the equivalent of the qualified plan’s survivor annuity under the settlement options, the survivor-annuitant will have a sizeable basis in the annuity. This basis will be recovered in a pro-rata fashion under the rules of Code section 72, leaving only a portion of each payment subject to income tax.

Therefore, in determining the amount of insurance required so as to match the survivor benefit payable from a J&S annuity from the plan, planners have to consider the difference in the taxation of the benefits. Much less insurance is necessary to match the after-tax survivor payments from the qualified plan than to match the before-tax payments from the pension plan.

Similarly, planners must recognize that the amount which will be available to pay premiums on life insurance if the participant elects a SL annuity rather than a J&S annuity must be adjusted for taxes. The participant will only have the after-tax difference available to pay premiums.

The value of the survivor benefit from a qualified plan J&S annuity will be included in the taxable estate of the participant. If the spouse is named as the beneficiary, it qualifies for the marital exclusion. However, if anyone other than the spouse is named as beneficiary, no exclusion applies.

If the participant retains any incidents of ownership in the life insurance policy, the death proceeds will be included in the estate. Similar to the survivor benefits from a qualified plan, if the spouse is named as beneficiary, the proceeds will qualify for the marital exclusion. If anyone else is named as beneficiary, the proceeds of the pension will be subject to estate tax.

However, if the participant creates an irrevocable life insurance trust, the death proceeds can escape inclusion in the estate. Often, even when the spouse is intended to be the primary beneficiary, an irrevocable life insurance trust can provide planning flexibility that is unavailable with the survivor benefit from a J&S annuity. For instance, the irrevocable life insurance trust can be arranged to handle contingencies, such as the possibility that the spouse will predecease the participant, by naming contingent beneficiaries. Such planning options are generally unavailable with a J&S annuity survivor benefit from a qualified plan.

Learn what planners should consider when analyzing a pension here.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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