Surrender insurance and transfer CV into other assets in the Plan

[cdavis25]

A particpant wants to surrender their insurance in the Plan and transfer the cash value into their account in other assets. The participant is 40 years old and still employeed. The CV is $10,000. The PS-58 costs (basis) are $1,000. The Plan does not allow for after tax contributions. What happens? How do they account for the 9k pre-tax and 1k after-tax? Is this a document issue?

[cdavis25]

Ok, so I now know you lose the ability to recapture the ps-58 cost if the policy is not distributed to the participant. Does the full 10k still get transferred to the other assets in the Plan? i.e. the participant will end up paying tax twice on the 1,000 (ps-58 cost)?

[Belgarath]

FWIW, I wouldn't be so sure the basis is lost. Opinions are on both sides of the fence on this - some say yes, some say no. PLR 8721083 (not positive about that number) provided that the basis is retained. And, this is certainly the common sense approach. Which approach you choose may be based upon advice of counsel, risk/reward analysis, and amount involved. For $1,000, most I've seen would consider it basis upon subsequent distribution.

[Bill Presson]

The cash value is already an asset in the plan. If the plan surrenders the policy, the cash value gets reinvested based on the plan rules, whether it's trustee directed or participant directed.

The plan is listed as the owner of the policy, right?

[cdavis25]

So, would they need to account for it in a separate after-tax bucket with the vendor? If the Plan does not allow for after-tax contribution or rollovers, then does it have any effect?

[BG5150]

So, would they need to account for it in a separate after-tax bucket with the vendor? If the Plan does not allow for after-tax contribution or rollovers, then does it have any effect?

* never mind *

[cdavis25]

Is it a rollover? The CV is already in the Plan. I am just thinking how I will get the vendor to pay out the 1,000 without withholding, when the time comes. Anyone else have this issue?

[BG5150]

^ sorry. I got this thread mixed up with another. I deleted my post.

Not a banner day for BG at BL.

[Bill Presson]

Is it a rollover? The CV is already in the Plan. I am just thinking how I will get the vendor to pay out the 1,000 without withholding, when the time comes. Anyone else have this issue?

You have a couple of different questions going here so you need to be very specific.

1. The cash value is not a rollover. It belongs to whatever source of money was used to pay the premium. For this purpose (moving it from the insurance company to current investments) just pretend it's in mutual fund A. There's really no difference.

2. The PS 58 costs (now I think called Table 1 costs) are the amount an insured reports as taxable income every year because they receive a current benefit from the insurance coverage. If the participant dies and the plan pays out the death benefit, the beneficiary may treat the reports costs as a basis in the payout and reduce the taxable amount. If the participant surrenders the policy, the taxable basis is lost and is not recovered.

[Belgarath]

You may find this both interesting and helpful. Granted that a PLR cannot be cited as precedent, the IRS has essentially followed this line of thinking in any situation I'm aware of. But I'd pass the buck to the client's ERISA counsel.

Private Letter Ruling 8721083
Annuities: endowment and life insurance, Employee contributions, Letter Ruling 8721083, (Feb. 25, 1987),Internal Revenue Service, (Feb. 25, 1987)

Letter Ruling 8721083, February 25, 1987

Uniform Issue List Information:

UIL No. 0072.05-00

Annuities: endowment and life insurance

- Employee contributions

This is in response to a ruling request dated April 17, 1985, as supplemented by a letter dated December 16, 1985, and a telephone conversation on February 3, 1987, submitted on your behalf by your authorized representative concerning the federal income tax consequences of distributions from Plan X.

The information submitted shows that Company M adopted Plan X, a defined benefit plan, on September 1, 1959. On May 5, 1977, the Internal Revenue Service issued a favorable determination letter as to Plan X’s qualification under section 401(a) of the Internal Revenue Code. A subsequent letter dated April 23, 1979, was issued, and an application for a new favorable determination letter is currently pending. Plan X’s trustee has maintained an investment fund to accumulate the funds necessary to provide the participants’ retirement benefits.

Prior to September of 1978, Plan X’s trustee invested the trust funds in whole life insurance policies on the lives of the various participants as well as in an auxiliary investment fund. For each year prior to September, 1978, Company M reported to each participant an additional amount representing the P.S. 58 costs (those costs of the participant’s current life insurance under Plan X). This amount was includible in the participant’s taxable income.

On September 12, 1978, Plan X was amended in its entirety and restated effective September 1, 1978. Two major changes caused by Plan X’s amendment were that death benefits for participants before age 65 were eliminated and the trust was to be funded entirely by employer contributions invested in various securities rather than partially, as before, in whole life insurance policies.

On October 5, 1978, Plan X’s trustees unilaterally decided to redeem the individual whole life policies and invested the trust proceeds thereof in securities. None of the participants had any control or voice in the conversion or change in Plan X’s investment vehicle. However, prior to the funding conversion, the participants could have assumed their individual whole life insurance policies if they paid the cash surrender value of the policies. None of the participants did so.

On February 11, 1980, Company M obtained a letter of approval from the Internal Revenue Service regarding the change in Plan X’s funding method. In part, the letter also approved the method by which the transition from the prior to the new funding method was to be made whereby Plan X’s unfunded accrued liability due to the change, plus the credit balance at the time of change, was to be amortized over thirty years.

In accordance with the foregoing, you have requested the following rulings:

1. That the entire employee benefit arrangement between the employee/participant and Company M as the trustee and plan administrator embodied in Plan X consisting of the various programs and deductions, contributions, and payments pursuant to Plan X is a single contract for federal tax purposes.

2. That the portion of the employer contributions which was included in the gross income of the employee/participant as P.S. 58 costs constitutes consideration paid for the ‘contract‘ by the employee/participant for purposes of determining the employee/participant’s investment in the contract.

3. That upon a distribution from Plan X with respect to a particular participant, the portion of such distribution representing a return of that participant’s investment in the ‘contract‘ shall be received, tax free, by the distributee.

4. That in completing a Form 1099 for any year in which there was any distribution from Plan X with regard to a participant who was previously taxed on a portion of such distribution as P.S. 58 costs, the trustee of Plan X shall not include the portion attributable to such P.S. 58 costs in the amount of the distribution from Plan X taxable to the recipient but rather shall indicate that such portion is a tax-free return of investment in the contract.

Section 402(a)(1) of the Code provides, in part, that the amount actually distributed to any distributee by any employee’s trust described in section 401(a) which is exempt from tax under section 501(a) shall be taxable to such distributee in the year distributed under section 72 .

Section 1.72-2(a)(3)(i) of the Income Tax Regulations provides that for the purposes of applying section 72 of the Code to distributions and payments from qualified plans, each separate program of the employer consisting of interrelated contributions and benefits shall be considered a single contract. Section 1.72 - 2(a)(3)(ii) of the regulations lists the following types of benefits and the contributions used to provide them, as examples of separate programs of interrelated contributions and benefits:

(a) Definitely determinable retirement benefits.

(b) Definitely determinable benefits payable prior to retirement in case of disability.

© Life insurance.

(d) Accident and health insurance.

The regulation, however, states that retirement benefits and life insurance will be considered part of a single, separate program of interrelated contributions and benefits to the extent they are provided under retirement income, endowment or other contracts providing life insurance protection.

Example (7) of section 1.72-2(a)(3) (iv) of the regulations describes a situation in which a plan provided both retirement and death benefits through the purchase of individual retirement income contracts from an insurance company. Any distribution received by an employee under such a plan, whether attributable to one or more retirement income contracts and whether made directly from an insurance company to the employee or made through the trustee shall be considered as received under a single contract for the purposes of section 72 of the Code.

The facts of Example (8) of section 1.72-2(a)(3) (iv) of the regulations are similar to those with regard to Plan X prior to its 1978 amendment and change in funding method. In Example (8), the plan funded the death benefits and part of the retirement benefits by purchasing individual retirement contracts from an insurance company. The remaining part of the retirement benefits are to be paid out of a separate investment fund. Accordingly, the pension plan includes, with respect to each participant, two separate contracts for purposes of section 72 of the Code. The retirement income contract purchased by the trust for each participant is a separate program of interrelated contributions and benefits and all distributions attributable to such contact (whether made directly from the insurance company to the employee or made through the trustee) are considered as received under a single contract.

The facts submitted show that prior to the cashing out of the whole life insurance policies, Plan X’s trust fund consisted of these policies and an auxiliary investment fund. However, after the redemption of the policies on October 5, 1978, and the investment of their proceeds in securities, the trust fund was composed only of securities. As the examples in the regulations indicate, the individual whole life insurance policies and the investment fund were two separate programs. But after the whole life insurance policies were redeemed and invested in securities, Plan X became a single program of interrelated contributions and benefits.

Accordingly, with respect to your first ruling request, we conclude that the entire employee benefit arrangement of interrelated contributions and benefits between the employee/participant and Company M as the trustee and plan administrator embodied in Plan X after the redemption of the whole life policies is a single contract for purposes of section 72 of the Code. However, please note that in conformity with Example 8 of section 1.72-2(a)(3) (iv) of the regulations, all benefits and distributions attributable to the redeemed whole life policies are, for purposes of section 72 , considered as received under a single contract.

Section 72(a) of the Code provides, as a general rule, that gross income includes any amount received as an annuity under an annuity, endowment, or life insurance contract.

Section 72(b)(1) of the Code provides, in part, that gross income does not include that part of any amount received as an annuity which bears the same ratio to such amount as the investment in the contract bears to the expected return under the contract.

Section 72(m)(3) of the Code provides, in part, that any deductible contribution to a trust described in section 401(a) and exempt from tax under section 501(a) , which has been used to purchase life insurance protection for a participant is includible in the gross income of the participant for the appropriate taxable year.

Section 1.72-8(a)(1) of the regulations provides that an employee’s investment in an annuity contract includes those employer contributions to the benefit of an employee or his beneficiaries to the extent they were includible in the employee’s gross income under subtitle A of the Code or prior income tax laws.

Section 1.72-16(b)(4) of the regulations, dealing with the treatment of the cost of life insurance protection, however, provides that the amount includible in the gross income of the employee under this paragraph shall be considered as premiums or other consideration paid or contributed by the employee only with respect to any benefits attributable to the contract (within the meaning of section 1.72 - 2(a)(3)) providing the life insurance protection.

Thus, this provision is authority for treating an individual’s P.S. 58 costs under Plan X as consideration paid by the employee for the original life insurance contracts because these amounts were included in the employee’s gross income. In addition, section 1.72 - 16(b)(1)(ii) of the regulations provides that the rules of that paragraph (relating to whether employee contributions constitute consideration for benefits received) apply whether the proceeds of the contract are payable directly or indirectly to the participant. Proceeds are considered indirectly payable to a participant, for this purpose, if they are paid to the plan’s trustee, who then disburses them. Since, in the instant case, the proceeds of the redeemed policies were payable to Plan X’s trustees to invest in securities so as to fund the plan benefits, they are thus paid indirectly to participants and the rules in the regulations apply as well as if Plan X distributions consisted of the life insurance contracts and the participants personally cashed in the contracts.

Accordingly, in response to your second, third and fourth ruling requests, we conclude as follows:

2. The portion of the employer contributions which was included in the gross income of Plan X’s participants as P.S. 58 costs constitutes consideration paid for the ‘contract‘ by the participant for purposes of determining a participant’s investment in the ‘contract.‘

3. Upon a distribution from Plan X with respect to a particular participant, the portion of such distribution representing a return of that participant’s investment in the ‘contract‘ shall be received, tax free, by the distributee.

4. In completing Form 1099 for any year in which there is any distribution from Plan X with regard to a participant who was previously taxed on such portion of the distribution as P.S. 58 costs, the trustee shall indicate that such portion is a tax-free return of investment in the contract.

Please note that for purposes of the conclusions reached in ruling requests 3 and 4, section 1122© of the Tax Reform Act of 1986 has amended section 72(b) of the Code so that an individual whose annuity starting date is before January 1, 1987, must exclude the same percentage of each distribution from taxation no matter for how long annuity payments are received. An individual with a later annuity starting date, however, must stop excluding a portion of the distribution from taxation when the individual has recovered tax-free the actual amount of employee contributions.

This ruling is based upon the assumption that Plan X was and will be qualified under section 401(a) of the Code and its related trust was and will be exempt from tax under section 501 (a) at all time relevant to this ruling request.

A copy of this ruling has been sent to your authorized representative in accordance with the power of attorney on file with this office.

Allen Katz

Chief, Employee Plans

Rulings Branch

[Bill Presson]

Belgarath, thanks for that. I actually now remember seeing that PLR when it came out. My fuzzy recollection is that there were differences between the recovery if the policy or "contract" was surrendered to pay the benefit (no recovery) or if the policy or "contract" was annuitized to pay the benefit (recovery).

In the instant case, not sure it's worth the trouble for $1,000, but the op is free to get a more specific opinion.

[cdavis25]

It isn't worth getting an ERISA attorney's opinion for the lost taxes, since the amount is not that large. Thanks for the information and help.

[Bird]

fwiw, I don't think it was fully answered - you don't want a separate after-tax account. It's part of the "regular" money but it simply has basis and you show that as non-taxable (and non-rollable) at the time of eventual payout (unless you just ignore the basis entirely...I'd show it though, based on the PLR cited).