401k Cash Surrender Value

[52626]

Plan allowed insurance and the participant was paying premiums from his account. Participant decided he no longer wanted the insurance and contacted the insurance provider and cancelled the policy.    The provider sent him a check for the Cash Surrender Value. The insurance company was not responsible for the 1099R.

The Cash Surrender Value was $56,000. The plan issued a 1099R to the participant for the full Cash Surrender Value.  The participant stated the insurance company told him he would only pay tax on the gain of the policy - difference between the Surrender Value and the investment in the policy, this was approximately $9,356.

Since the premiums were paid with pre tax dollars, isn't the total Cash Surrender Value taxable income?  I am not sure the insurance company realized this was held under a 401(k) Plan vs a private policy.

Thoughts

Thanks.

 

[Bri]

First thought is whether or not any distribution was actually permitted under the terms of the plan. 

If that's a no, then the proceeds have to go back to the plan and the flowchart for the fix-it process ends up completely different.

[52626]

The participant was over the age of 59 1/2 so taking the CSV would be an in service distribution as allowed under the plan.

[cathyw]

The participant should have been taxed each year on the PS-58 cost.  That becomes basis in the contract and upon surrender the cash value in excess of the cumulative PS-58 costs is taxable.

[Jakyasar]

Curious how the participant cancelled the policy (unless done thru sponsor/trustee), unless he/she is the owner/trustee. Policy is supposed to be owned by the plan and an asset of the plan. If the policy is cancelled aka surrendered, cash value is an assets of the plan and cannot simply be distributed.

what am I missing here?

[Bird]

On 3/10/2023 at 1:16 PM, 52626 said:

I am not sure the insurance company realized this was held under a 401(k) Plan vs a private policy.

One of several possible problems, none of which are surprising.

Yes, the policy should have been owned by the plan and proceeds payable to the plan. 

Agree with comments above that it was in fact a distribution from the plan, subject to normal distribution processes, taxes (and 20% withholding for most of it), except that cumulative PS-58 costs are recoverable as basis.

 

[ErnieG]

Agree with comments above, with the exception of the basis.  If this is a self-employed individual there is no investment in the contract, no basis generated.  Additionally, basis follows the contract.  There is a PLR supporting a surrendered contract retains its basis for tax purposes however that conflicts with the Treas.Reg. and Rev. Rul.

[John Feldt ERPA CPC QPA]

And if self-employed, take a look at what code section 404(e) says about the deduction. Also discussed in the EOB. 

[FPGuy]

Full cash value taxable, less cumulative annual economic benefit value imputed income determined under Table 2001 (formerly PS 58 Table) or carriers 1 year term rates, if lower - and under any calculation actually recognized for tax purposes by insured. Except for self employed, imputed income equivalent not imputed but non-deductible, so no basis to recover. Because full cash value taxable, basis becomes equal to cash value so no "gain" per insurance company of difference between cumulative premiums and cash value. In instant case, $56K less imputed income derived basis, if applicable, taxable as ordinary income. Insurance company calculated "gain" inapplicable despite a likely 1099 from them indicating otherwise. Little known or, I think, used "loophole" is to extent that taxable element of proceeds applied within 60 days to non-transferable annuity, distribution will be non-taxable (akin to IRA rollover). Yes, proceeds should have been paid to plan, and yes, issue with ignoring required tax withholding.