Life Insurance/457 Plan

[Guest RARogers]

Several clients have 457 plans with life insurance - set up by insurance agents. The employee chooses the life insurance as an investment. If the employee dies while employed, the death benefit from the insurance is paid to the employer, but it is then paid to the employee's beneficiary. The employee doesn't recognize any current income for the insurance coverage. Apparently when the employee dies while still employed, the entire amount is treated as taxable income and is included in the estate. If the employee retires, the contract is distributed to the employee, who takes the cash surrender value into income.

I think this is a problem, in that I think that the insurance coverage was taxable income to the employee each year that the insurance was in force. The 457 regulations say that you can have insurance in a 457 plan, and that it will be treated as described above, BUT the death benefit has to be paid to the employer, and the employer must be under no obligation to pass through the death benefits to the employee's beneficiary. This is not the case here, in that the plan provides that the beneficiary gets the death benefit determined by the face value of the insurance.

I don't see how you can provide a pretax death benefit, unless it complies with IRC ss 79.

Any insights would be greatly apprceiated.

[Guest CVCalhoun]

I think the regulations you are referring to predate the change in section 457(g), which now requires that governmental 457 plan assets be held in trust. (You can click here to see an article about that legislation.) Before the change, governmental 457 plans were forbidden to fund their plans. Thus, assets in any trust under a 457 plan (including life insurance and/or a death benefit) had to be subject to the claims of the employer's creditors. However, the exact opposite is now true--all assets must be protected from the employer's creditors.

[Guest RARogers]

CVCalhoun - Are you saying that the reason the death benefit might have had special treatment - pre-457(g)- is that it was provided under an unfunded plan? Is that the way a death benefit under a nonqualified (non457) plan works? I guess that if that's the way an unfunded non457 plan treats a death benefit, that the same rule would apply to 457 plans.

I think perhaps you could have life insurance in a 457 trust - but then you wouldn't have the rationale for excluding the value of the death benefit coverage from current income - so you'd have to get into some sort of PS58 analysis.

[Guest CVCalhoun]

Yep, that's what I'm saying.

And you're right, the PS 58 costs would presumably be includible in income, the same way they have been all along for qualified plans. And the ultimate death benefit would be taxable. Not to mention the fact that earnings on life insurance contracts are often lower than earnings on other investments, based on their tax-exempt status--something which would be irrelevant if the contract were held by the plan. Thus, you would want to look carefully to make sure that the particular life insurance contract was a prudent investment. But other than that, there should not be a legal barrier to having the contract held by the 457 trust.

[Note: This message was edited by CVCalhoun]

[Everett Moreland]

I question whether life insurance protection under a trusteed 457(a) is currently taxable. Unlike qualified plans, participants in 457(a) plans are not taxable under Section 72. See Internal Revenue Code §§ 72(m)(3), 402(a), 403(a)(1), 403(B)(1), and 457(a); Treasury Regulation §§ 1.61-2(d)(2)(ii)(a), 1.403(a)-1(d), 1.403(B)-1©(3), 1.404(a)(3)(a), and 1.457-1(B)(2) Example (7). See also 1998 CCH Standard Federal Tax Reporter ¶ 6140.032, stating that Section 72(m)(3) was needed to overrule the provision in Sections 402(a) and 403(a)(1) that amounts are not taxable until distributed.

[Everett Moreland]

As a follow-up on my posting of yesterday, Revenue Rulings 54-52 and 56-634 strongly suggest that life insurance protection under a 457 plan should be currently taxable. However, Section 72 gives the participant basis for the current taxation of life insurance protection under a qualified plan, see 1.72-16(B)(1) and ©(3) Example (1), but Section 457 has no clear rules for giving basis (but 1.457-1(B)(2) Examples (5) and (6) suggest that basis is possible). More important, Section 72 allows the Section 101(a) exclusion to apply to a portion of the death benefit under a qualified plan, see 1.72-16(B)(2)(ii), but Section 457 does not, see 1.457-1© and PLR 9008043 (11/28/89). The assumption underlying Section 457 is that benefits payments are wages. See 35.3405-1 A-23 ("amounts paid from a deferred compensation plan described in section 457 are wages under section 3401(a)"); 1998 Instructions for Forms 1099, 1098, 5498, and W-2G, at 29 ("Report distributions to plan participants from nonqualified deferred compensation plans, including section 457 plans, on Form W-2, not on Form 1099-R."). If the above rules survive the trust requirement, which I assume they do until Section 457(a) is amended to tax distributions under Section 72, then the cost of current life insurance protection under a 457 plan should not be taxable. This seems to be confirmed by Section 457(g)(2)(B) ("notwithstanding any other provision of this title, amounts in the trust shall be includible in the gross income of participants and beneficiaries only to the extent, and at the time, provided in this section"), discussed at H.R. Rep. No. 104-586 at 118; S. Rep. No. 104-281 at 86 & n.70; H. R. Rep. No. 104-737 at 251; and Joint Committee General Explanation at 163 (JCS-12-96).

[Guest RARogers]

Thanks for your thoughtful comments and references.

It seems that there are a few details to work out on the funded 457 plan. The 457 concept is that payments are wages, but the idea of "wages" seems inconsistent with a funded deferred benefit. Perhaps for the funded 457 plan, ss 72 will be applied - it makes sense. But that would mean having different rules for 457 plans for governmental and tax exempt organizations. Just what everyone needs - another type of retirement plan (with lots of unique rules)!