C—UL And VUL—Tax Advantaged Asset Accumulation

Qualified retirement plans have for decades been an important vehicle through which employers have provided tax-advantaged asset accumulation and retirement benefits for employees. Retirement plans which satisfy various criteria established under the Internal Revenue Code (the “Code”) and under the Employee Retirement Income Security Act of 1974 (“ERISA”) are granted certain important tax benefits. The term "qualified plan" specifically refers to plans that have met the requirements set forth in Code §401(a) and §403(a).

Life insurance contracts represent another vehicle for tax-advantaged asset accumulation. In the case of an individual or a small business the creation of substantial cash values through a life insurance contract can, in certain circumstances, be an effective asset accumulation vehicle. The purpose of this Subdivision is to examine the efficacy of life insurance contracts’ “living proceeds” as an asset accumulation vehicle and provide context through a comparative tax analysis.

Primary Tax Advantages Of Qualified Plans

The essence of a qualified plan is the setting aside of funds in a trust or other type of institutional custodial account for the accumulation of savings, and income on the investment of the contributed funds, for the benefit of the plan participant. The objective is to build up an asset pool to be accessible in the future to meet a need of the participant which Congress deems socially significant enough that the saving process is effectively “tax sheltered.” Most commonly, this need is for retirement income. The basic tax advantages accorded to qualified plans may be summarized as follows:

Contributions To The Plan Are Tax Deductible When Made, Subject To Certain Limitations

Contributions made by an employer for the benefit of employees, or by a self-employed person for his own benefit, are deductible as business expenses. Contributions by employees to employer sponsored plans through payroll deductions are excludable from the employee’s income. Contributions to traditional (non-Roth) IRA accounts by individuals not covered by employment-related plans are allowed as an “above-the-line” deduction in arriving at adjusted gross income. Of course, in all cases there are limits on the amount that may be deducted. An exception to this general principle of current deductibility is the Roth IRA account. Although no deduction is allowed for contributions, the trade-off for this is that eventual withdrawals from the account will be tax-free, which is not the case with other types of qualified plans.

Contributions By Employers Are Not Taxed As Additional Compensation To The Employee Beneficiaries

Ordinarily, amounts irrevocably set aside by an employer for the benefit of an employee would be taxable to the employee as additional compensation for services. However, under the special treatment accorded qualified plans, employer contributions are specifically excludable from the gross income of the employee-plan holder.

Income Earned From Investment Of The Funds In The Plan Account Is Tax-Free When Earned

This, of course, allows for more rapid compounding of gains over the life of the account, realized income not being diluted by annual taxes. However, it must be realized that this type of tax “shelter” is not a permanent exemption from tax, but only a deferral. When funds are eventually withdrawn from the account, they are taxed as ordinary income at that time (except in the case of a Roth IRA and certain lump-sum distributions which qualify for reduced rates). Nonetheless, the long-term effect of the tax-free compounding of realized income during the shelter period will be quite substantial; the accumulated balance in a qualified plan account at retirement may be expected to far exceed the balance in a currently taxable account having the same duration, contributions, and rate of return on its investments.

Basic Requirements Of Qualified Plans

The following is a brief summary of the key elements of qualification, many of which, depending upon an employer’s particular business and labor circumstances, may be considered sufficiently disadvantageous or onerous that the employer will opt not to get involved, sometimes structuring some form of non-qualified plan instead.

An Employer-Sponsored Plan May Not Be Discriminatory In Favor Of Company Insiders Such As Highly Paid Executives Or Major Owner-Employees

In closely held businesses, where the owners’ primary objective is to provide benefits for themselves, without intending to benefit non-owner employees, the cost of providing benefits for the other employees, in order to comply with the non-discrimination requirements, sometimes eliminates qualified plans as an option.

Employer-Sponsored Qualified Plans Involve An Administrative Burden On The Sponsoring Employer

Initially, the plan must be submitted to the I.R.S. for qualification approval. Both the Internal Revenue Code and ERISA impose detailed rules regarding plan administration, record-keeping, disclosure, fiduciary standards, reporting, etc. For some smaller sized businesses the paperwork burden may be viewed as too onerous to warrant the establishment of a qualified plan.

Money Held In A Qualified Retirement Plan Account May Not Generally Be Withdrawn Until The Account Holder Attains Age 59½

While it is certainly advantageous to leave funds to continue to compound tax-free within the shelter of the plan account for as long as possible, a plan holder may wish, for whatever reason, to access his or her money at an earlier point. This is not absolutely prohibited, but because the shelter of a qualified plan is directed specifically at encouraging savings for retirement, the Internal Revenue Code imposes a 10 percent penalty on funds withdrawn prematurely, i.e., prior to age 59½. In recent years, the permissible uses of certain qualified plan funds have been expanded to include payment of college tuition, first-time home purchase and certain medical expenses. For such qualified uses, withdrawals may be taken prior to age 59½.

Distributions From A Qualified Plan Account Must Begin At Age 70½

Since the benefits of qualified plans are intended to promote savings for retirement, and not to build up a tax-sheltered pool of wealth for passing on to heirs, the Code requires that distributions from a qualified plan account must begin at age 70½ in certain minimum annual amounts. No such requirement applies in the case of a non-qualified plan, or a Roth IRA.

Qualified Plans are discussed in detail in Section 17.

IRAs and SEPs are discussed in detail in Section 17.1.

Cash Value Accumulation Through Life Insurance Contracts—Tax-Free Inside Build-Up

Although life insurance contracts have always been viewed as primarily to provide a pool of funds for survivors after the death of the insured, the cash value element in an insurance contract can be a source for funding various lifetime needs as well.

One of the great tax benefits of a life insurance contract is the accumulation of cash value for the benefit of the policy owner, year by year, without any current taxation of these annual increases [Code §7702(g)]. This is often referred to as “tax-free inside build-up” of cash value. In this important respect a life insurance contract is a tax “shelter” similar to a qualified plan: earnings can accumulate and compound tax-free as long as they remain within the shelter of the insurance contract or qualified plan.

Given that, for purposes of our discussion, the insurance contract is being utilized as an accumulation vehicle the objective would be to have premiums allocated to the greatest extent possible to the cash value element, with as little as possible to the purchase of insurance protection. There are, however, statutory standards (Code §§ 7702 and 7702A) under which a life insurance contract will not qualify as a life insurance contract (or may be classified as a modified endowment contract) if the premiums are allocated so heavily toward cash value accumulation, and so little to insurance protection, that the arrangement is considered an investment fund disguised as a life insurance policy. If these standards are not met, then either the inside build-up of investment income will be taxable as earned, or the eventual distribution of this income will be unfavorably treated.

Comparative Tax Analysis

The Contribution Phase

For purposes of our academic analysis we will assume that a fixed amount is paid by an employer (a) as a contribution to a qualified retirement plan account for a given employee; and (b) as a premium payment into a variable universal life insurance contract owned by the employee.

Income Tax Consequences and Overall Costs to Employer

The employer’s contribution to a qualified plan for the account of the employee will be allowed as an income tax deduction for the employer, provided that it does not exceed the statutory maximum [Code §404].

With respect to the employer’s payment of premiums on the employee’s insurance contract, this will generally be deductible by the employer as supplemental compensation for services (as part of the employer’s ordinary and necessary business expenses under Code §162).

The deduction for both the qualified plan contribution and the insurance premium payment are limited by the overall requirement of Code §162 that the aggregate compensation of all types realized by the employee may not exceed reasonable compensation for the services actually rendered.

It is important to note that one of the requirements for deductibility in the case of a qualified plan is that the plan not be discriminatory in favor of owner-employees or highly compensated employees. This, of course, is not a requirement in the case of premium payments through insurance contracts. This difference can be a very important factor, because it means that the employer can target one or more specific employees for the insurance-based arrangement, without the need to include any other employees. This is especially important in the case of a closely held business having both owner-employees and non-owner-employees, when there is no motivation to benefit the non-owner-employees. In such a case, whatever the cost of contributions for the owner-employees under an insurance arrangement, the cost of an equivalent contribution level for the owner-employees under a qualified plan will be effectively “inflated” by the requirement to make contributions for the non-owner employees as well. Or, stated another way, under the insurance arrangement, a greater portion of the money available for retirement funding can be channeled to the owner-employees.

Income Tax Consequences to Employee

Contributions to a qualified plan by an employer will not be taxable income to the employee when made, even though the employee may immediately be fully vested, with no risk of forfeiture [Code §§ 402 and 403].

By contrast, employer payment of insurance premiums on a policy owned by the employee will represent taxable income to the employee. This is one of the significant advantages of the qualified plan in our comparative analysis. The long-term benefit of the portion of the insurance premium that goes into the investment pool must be partially offset by the long-term cost of the tax payable with respect to the inclusion of the premium payment in the employee’s gross income.

The Accumulation Phase

In the accumulation phase we compare the income tax and other factors impacting the build up of values through compounding of investment income.

Income Tax Treatment of Accumulating Income

In the case of a qualified retirement plan, the income earned and credited to the employee’s plan account is generally tax exempt [Code §501(a)] until withdrawn.

Similarly, the inside build-up of income in a life insurance contract is not includable in the gross income of the employee/contract owner.

The Distribution Phase

In the distribution phase the scope of the analysis of differences between the two vehicles is much broader. It includes both income tax and estate tax differences.

Income Taxation of Distributions

In general, benefits received from a qualified plan are taxable as ordinary income when received. In cases where the participant has a basis in his or her plan account—for example, if non-deductible employee contributions had been made—the portion of each benefit payment which represents recovery of basis (determined by the annuity taxation method of Code §72(e)) is not taxable [Code §402(a)]. Although taxation may be deferred by a qualifying rollover, this is merely a deferral, and taxation as ordinary income will eventually occur, even if assets remain in a sheltered account until it becomes income in respect of a decedent at the employee’s death.

Withdrawals of cash value from an insurance contract are taxed quite differently. Except in the case of withdrawals in the form of an annuity, the owner is first allowed tax-free recovery of his or her basis; i.e., an amount up to the cumulative total of premium payments into the contract may be withdrawn tax-free. Once the cumulative total of withdrawals exceeds the cumulative premiums paid in, all withdrawals thereafter are taxable as ordinary income. Where the owner chooses to withdraw the entire cash balance in the form of an annuity over a term of years or life, the annuity method of Code §72(e) applies. Under the annuity method, a ratio is established under which the taxpayer’s basis is recovered ratably over the anticipated duration of the annuity payout period; each annuity payment is allocable partly to tax-free recovery of basis and partly to taxable income.

The annuity method is essentially the same as is applied to the taxation of distributions from qualified plans (whether or not such distributions are annuitized), but the tax-free recovery of basis is not generally of great significance in a qualified plan, since it only applies when a plan account has received non-deductible employee contributions. Moreover, for purposes of our discussion, we will be assuming that there are no employee contributions to either vehicle.

Tax-Free Access to Cash Value

It is possible to withdraw a substantial portion of the cash value of an insurance contract on a tax-free basis. The initial withdrawals are tax-free until the full amount of the basis in the contract is recovered. Thereafter, funds may be accessed in the form of loans, which of course, do not represent taxable withdrawals. There is a slight cost to this alternative, albeit far less than the income tax on withdrawals in excess of basis. Thus, the interest, which must be paid on the policy loans, will exceed the rate at which earnings are credited to the policy with respect to the borrowed portion of the cash value. However, this cost is typically not an out-of-pocket expense to the policyholder, but is merely netted against the cash value of the policy.

A policy loan may be held outstanding indefinitely, and if held outstanding until death, will be offset against the policy death benefit, with no income tax at that time; thus, the income tax will have been permanently avoided. On the other hand, if the policy, for any reason, is allowed to lapse prior to the insured’s death, the tax impact of an outstanding loan balance is quite different: to the extent that the then outstanding loan balance exceeds the tax basis in the policy, the excess is taxable as ordinary income. (The consequences of such a situation are illustrated in the 1999 Tax Court case of Atwood v. Comm’r., T.C. Memo 1999-61.) Thus, it is of vital importance that the insurance contract used in such an arrangement be properly structured so as to avoid lapses to the fullest extent possible.

While loans may also be taken from qualified plans, they are limited to a relatively small amount and relatively short duration, and are not a vehicle for permanent tax-free withdrawal, as are insurance policy loans (assuming a policy that does not lapse).

The Timing of Withdrawals

In order to help assure that the accumulation of tax-sheltered funds in a qualified plan are used as a resource for retirement, the Code imposes penalties for both pre-retirement withdrawals and failure to make adequate distributions during retirement. Thus, a penalty of 10 percent of the income resulting from a qualified plan distribution is imposed if the distribution is received before the participant attains age 59½. (An exception applies with respect to pre-59½ distributions if the distribution is a part of a series of substantially equal periodic payments (at least annually) made for the life or life expectancy of the employee or the joint life expectancies of the employee and his or her designated beneficiary. Certain other exceptions also apply.) [I.R.C. §72(t)]

Once the account holder reaches age 70½, minimum annual distributions must be commenced (computed so as to project full distribution in annual installments over the life expectancy of the account holder or, in general, the joint-and-survivor life expectancies of the account holder and a hypothetical individual 10 years younger than the account holder). If, after the age 70½ commencement date, actual distributions fall below the required minimum, a penalty tax equal to 50 percent of the shortfall is imposed.

No withdrawal requirements are imposed with respect to a life insurance contract. Cash value can be withdrawn without limit prior to age 59½ with no tax penalty (as long as the contract is not a modified endowment contract (MEC)), and there is no requirement that any amount be withdrawn after age 70½. Thus, the life insurance contract offers flexibility in the utilization of the accumulated cash values during lifetime or by eschewing withdrawals during lifetime and passing the full value to beneficiaries upon death. The absence of any distribution requirement represents an advantage over a qualified plan in the case of a wealthier individual who would not need distributions from a tax-sheltered vehicle to maintain his or her standard of living after retirement. The continued tax-free compounding of cash values within the insurance contract will increase the asset pool that will pass to heirs, income tax-free---and, as discussed below, it is possible that it can be passed free of estate tax.

Consequences Upon Death

The death of a qualified plan account holder with a remaining vested interest in a qualified retirement plan account can result in a double-whammy of income and estate tax. The balance to the credit of the plan participant upon death (to the extent it exceeds any basis in the account) is taxable, as income in respect of a decedent (“IRD”), to the beneficiary(s) entitled to receive such balance, whether in continuing annuity payments or in a lump sum [Code §691]. The same amount that is subject to income tax is includable in the gross estate of the decedent and potentially subject to estate tax. No estate tax will apply, however, if the beneficiary of the retirement plan is a surviving spouse (since the marital deduction would apply) or if decedent’s taxable estate is less than the available estate tax exemption amount. If the income in respect of the decedent does not go to a surviving spouse, and is subject to estate tax, the estate tax attributable to the income is allowed as a deduction against the income in the recipient’s income tax computation.

With respect to a life insurance contract no portion of the death benefit will be subject to income tax. While the entire death benefit will be subject to estate tax (except if, as in the case of the qualified plan balance, the beneficiary is a surviving spouse or the taxable estate is below the estate tax exemption amount), the estate tax can be avoided if the ownership of the insurance contract is structured in such a way that the decedent held no incidents of ownership in the contract at the time of death.

Tabular Comparison Of Tax Characteristics Of Qualified Retirement Plans And Life Insurance Policy

Qualified Plan	Insurance Contract
Contribution Phase
Employer contributions deductible, up to statutory limits.	Employer premium payments deductible with no limit other than “reasonable compensation” standard.
Employer contributions not taxable to employee when made.	Employer premium payments are taxable to employee.
Accumulation Phase
Income earned in qualified plan account is tax-free when earned.	Inside build-up of cash value in insurance contract is tax-free.
Plan account subject to transaction costs associated with maintaining investment portfolio and plan administration.	Cash value build-up subject to sales and administrative loading charges.
	Annual cost of pure insurance protection deducted from Cash Value.
Distribution Phase
Distributions generally taxable as ordinary income as received.	Withdrawals are tax-free to the extent of the cumulative total of premiums paid in (basis), thereafter, ordinary income. Annuitized distributions are part income and part tax-free recovery of basis. Policy loans are income tax-free. [Assumes policy is not a Modified Endowment Contract]
10% penalty applies to distributions prior to age 59½; Distributions must begin at age 70½ ; if the amount distributed is less than the required minimum a penalty is imposed on the difference.	No limitation or requirements regarding timing of distributions.
Balance remaining at death is taxable to beneficiary as income in respect of a decedent.	No income tax on cash value (or any portion of the death benefit) at death of insured.
Balance remaining at death not passing to surviving spouse is subject to estate tax.	Death benefit not passing to surviving spouse is subject to estate tax, but estate tax can be avoided with irrevocable life insurance trust.

Cross References

The federal income tax benefits afforded flexible premium life insurance contracts are a major advantage of universal and variable universal life insurance products. The Income Taxation of Life Insurance is discussed in detail in the following Subdivisions of Section 19.1:

A—Definition Of "Life Insurance" For Income Tax Purposes

B—Taxation Of Proceeds Payable At Death

C—Taxation Of Proceeds Payable During Life

D—Gain Or Loss On Surrender Or Sale

E—Section 1035 Exchange Of Contracts

F—Tax Treatment Of Premium Payments

G—Tax Treatment of Policy Loan Interest