This is called a linked distribution. You don’t cash in the policy. You have the insurance company change the ownership from your retirement plan to you, similar to taking shares of stock or any asset from your plan. This is a taxable event. How much tax do you pay? You pay income tax on the “fair market value” of the policy. No one knows what this number is, but this is where you get your accountant and financial advisor together and they will figure it out. (Good news—there is an industry called the “life settlement industry” that buys life insurance policies and their bid for your policy should be something that your advisor and accountant may want to rely on).
Next, you gift the policy to your heirs. For gift tax purposes the value of the policy is the “interpolated terminal reserve” and the insurance company can give you that information. Based on current rules, you can give $12,000 per year per donee without considering gift taxes. If you’re married, your spouse can do the same. So if you have four heirs, then you and your spouse can gift $96,000 annually (2 x $12,000 x 4 heirs).
If the interpolated terminal reserve of the policy is $166,000, then you can gift the policy over two years and use up none of your estate exemption. If the interpolated terminal reserve is more than you can remove from your estate using the annual exclusion, then you may need to use up some of your estate exemption.
So what’s the payoff for all of this?
- You get to buy life insurance with pre-tax dollars.
- When distributed from the plan, the taxable value could be less than the premiums invested (depending on fair market value).
- You gift the policy out of your estate.
- You get the leverage provided by the life insurance—as an example for a 60-year old male, $1 million goes into the policy $4,124, 862 comes out as a death benefit.(1)
(1) ING Guaranteed Premium UL; preferred male, age 60, $1 million single pay premium (9-27-04). Information is hypothetical and actual results could vary; The purchase of life insurance is subject to health underwriting; Benefits and premiums will be determined, upon the applicant’s age, gender, smoking status and health; Premiums and benefits vary widely among insurance carriers; Premiums and benefits stated above are subject to change in the future. Purchase of insurance involves fees, commissions, and surrender charges.