Taking a life insurance policy as a Distribution

[KateSmithPA]

A participant, who is over age 59 1/2, wants to remove her life insurance policy from her 401(k) plan. That is, she wants to keep the policy but wants to own it outside the plan (I don't know why). I believe that she can take possession of the policy outside the plan and that the consequences are that she is liable for income tax on the cash value of the policy when distributed.

Am I correct in this? And, since there will not be any actual cash involved, is there a problem with the mandatory 20% withholding rule?

[pmacduff]

Kate - IF the plan allows for in-service distributions at 59 1/2+, then she can take distribution of the policy, otherwise, she would have to wait for a distributable event.

Now, if eligible for distribution, there are actually two ways that I know of that the policy can be addressed: 1) Participant takes over ownership of the policy and continues paying premiums personally. In this instance, she would receive a 1099-R form for the cash value upon transfer of ownership, (even though she did not actually receive those funds, they are available to her once she assumes ownership); and 2) Some policies allow for the total cash value to be taken from the policy in the form of a loan. The proceeds are then deposited into the plan and remain tax deferred until the participant takes that cash in distribution. The policy ownership is then transferred to the participant who can continue paying premiums personally. The loan amount (once the policy is signed over to her personally) can be repaid into the policy by the participant with other monies or if it remains unpaid, will usually reduce any death benefit. In this scenario, the participant would not receive a 1099-R form as the policy has no cash value on transfer. Hope this helps.

[QDROphile]

For withholding, take a look at Treas. Reg. section 31.3405©-1 Q&A-9

[Guest JimJ]

Maybe I have not understood everthing said, but could the participant simply purchase the policy out of the plan. Meaning, could she come out of pocket for the cash value which would remove the policy and not create a distribution?

[pmacduff]

My feeling is that no, she can't. For one thing, it would be after tax dollars she would be putting into the plan, the plan would have to allow for that. If she has the money equal to the cash value outside the plan, why not strip the cash value in the form of a loan, deposit that into the plan; Trustee can then transfer ownership, and the participant can pay back the policy loan once the policy is outside the plan? It accomplishes the same thing, and creates no taxable event for the participant. Plus, the original stripped cash value is safely tax deferred in the Plan for later distribution. If anyone has a different opinion, I'd like to hear their thoughts, too.

[QDROphile]

Why wouldn't a sale of a plan asset to a participant be a prohibited transaction? And if it is, what would be the exemption for the proposed transaction?

[pmacduff]

It isn't the "sale of a plan asset" to a participant. If the plan allows in-service distributions on or after 59 1/2, the Trustee is simply allowing the participant to take distribution of the insurance policy as opposed to a cash distribution. That is not a prohibited transaction just an in-service distribution. Also - the cash from the policy remains in the plan - no actual distribution to participant. Imagine, if you will, another scenario...life insurance policies are not supposed to remain in effect in a Qualifed Plan after attainment of Normal Retirement Age. What if you had a participant continue working after Normal Retirement Age who wanted to keep his/her insurance coverage? Wouldn't the Trustee need to transfer ownership to that participant as well? Would you consider that a prohibited transaction? If so, how would the insurance be handled? Just some food for thought.

[QDROphile]

I was referring to JimJ's proposal.

[pmacduff]

Sorry QDROphile...I'm with you now!

[Michael Devault]

I believe that Prohibited Transactoin Class Exemption 92-6 may shed some light on this. It says that it's OK to sell an individual life insurance or annuity contract to a participant, a relative of a participant, an employer or another employee benefit plan if:

1. The participant is the insured under the contract,

2. Such relative is a family member,

3. "The contract would, but for the sale, be surrendered by the plan"

4. If sold to anyone other than the insured, the insured has to agree to the sale,

5. The amount received by the plan is at least equal to the amount necessary to put the plan in the same cash position as it would have been if it had retained the policy and surrendered it,

6. the plan can't discriminate in favor of plan participants who are officers, shareholders or HCEs.

Hope this helps out!

[Guest P A Weick]

Prohibited Transaction Class Exemptions 77-8 and 92-6 allow a participant to purchase insurance on his/her life from a plan.

[Guest JimJ]

Going back to my original question and based on this information, is it OK to do? (see below)

Maybe I have not understood everthing said, but could the participant simply purchase the policy out of the plan. Meaning, could she come out of pocket for the cash value which would remove the policy and not create a distribution?

[Michael Devault]

In my opinion, yes. The prohibited transaction exemption would seem to allow the proposed transaction.

[pmacduff]

I still say no, she cannot purchase the policy directly from the plan. The policy must first be stripped of its cash value, ownership transferred to her by the Trustee, participant replaces the cash value personally once the policy is outside the plan. My reasoning is that her monies entering the plan for the purchase would be considered "after tax" monies similar to a loan repayment. In order to maintain the tax deferred status, my opinion is that the replacement of cash value by the participant has to occur outside of the plan. Most plans do not allow after tax contributions and those that due have testing, etc.

[Guest Bandb]

Pre-tax, post-tax has nothing to do with it.

This is a change in investments that are available under the plan. In practice, it occurs.