Distribution from 401(k) to ILIT

[Guest SSSP]

I read a post recently that I think is misstated (unintentionally). Here are the facts that I would LOVE to get comments on.

Individual business owner is wanting to make a charitable gift of his 401(k) assets to charity. However, he wants to take some of the funds from the plan and "distribute" and purchase a life insurance policy with the beneficiary (most likely) being family. It is possible that they could make the charity the beneficiary as well.

What I thought I read elsewhere (but don't believe this is possible) is that once the funds are distributed from the plan, they are taxable, regardless of an ILIT, correct? Whether the end beneficiary is the charity of the family, correct?

If that answer is YES, my question is why would an ILIT be necessary as the funds would have been taxed and, therefore, the purchase of life insurance with such funds would be not taxable to the beneficiaries. Am I missing something?

Thanks.

Sam

[ETA Consulting LLC]

The ILIT, in this case, would actually purchase the life policy from the plan. It would not be a taxable distribution, but merely having the ILIT write a check to the plan for the fair market value of the policy.

Good Luck!

[shERPA]

Generally the ILIT is used to keep the policy proceeds out of the estate.

There are other strategies involving charitable deductions and insurance that may be available depending on a number of factors, none of which I am qualified to discuss.

[Guest SSSP]

ERISA and Sherpa, thanks. One quick question...more to ERISA. The way I understand the rules is that a participant (over the age of 59 1/2) could take the policy out of the plan as a taxable distribution and have personal control over the policy, correct. I am assuming that the distribution could occur at any time from the plan and the participant would be taxed on the Fair Market Valuation of the policy at the time of the distribution? Not that it matters for this conversation, but I also believe that the life insurance company cannot assign an FMV, but rather the FMV must be identified by a third-party, independent source from the plan and the life insurance company. Have you heard the same?

Also, when plan funds are used, I understand that any amount of rollover funds (funds that came into the plan from other retirement plans) can be used to pay policy premiums, however only 49.99% of contributed funds can be used toward whole life policies and 25% for term and universal life policies...correct? Thanks so much!

[Bird]

Yes, a participant can take the policy out of the plan after 59.5 - if the plan permits such (presumably in-service) distributions. It would be a taxable distribution.

I believe the proper valuation for the policy is the Interpolated Terminal Reserve, which is provided by the insurance company.

[shERPA]

A safe harbor for valuation of the policy is the PERC amount per Rev Proc. 2005-25. An appraisal can be another way to determine FMV, but it would not be an IRS safe harbor.

Per that Rev Proc. the interpolated terminal reserve "is appropriate only where the reserve reflects the value of all of the relevant features of the policy", whatever that means.

[Bird]

Thanks for the cite, I had forgotten that (and probably will again).

[ETA Consulting LLC]

SSSP,

I agree with Bird and ShERPA on the qualified plan aspects. You're trying to implement an estate planning strategy through a qualified plan. When you do this, you should be sure to account for the following:

1) The ILIT is a taxable trust. It is the investment in insurance (and I'm NOT saying that insurance is an investment, so let's not argue this) that provides for the tax deferral on the gains.

2) You must make arrangements to fund the ILIT while the policy is sitting in the plan. This will ensure you remain under to estate gifting limits (e.g. the annual and the lifetime limit). Just contributing a policy to an ILIT will give you a 3 year lookback; making death proceeds within 3 years considered an asset of the estate.

3) When placing a policy in an ILIT, you'd typically want a second-to-die (or survivorship) policy. The premiums are already lower since the policy will pay on the death of the 2nd insured, so this may beg the question of why you'd need a qualified plan.

Good Luck!