Life Insurance Swap

Welcome to the Retirement Learning Center’s (RLC’s) Case of the Week. Our ERISA consultants regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans, and other types of retirement savings and income plans, including nonqualified plans, stock options, Social Security and Medicare. This is where we highlight the most relevant topics affecting your business. A recent call with a financial advisor in Michigan illustrates a common question about strategies for life insurance policies with qualified plans.

"Can my client remove a life insurance policy from a qualified retirement plan without incurring additional tax liability?"

Highlights of the discussion

A Department of Labor (DOL) prohibited transaction exemption allows a plan participant to exchange or “swap out” a life insurance policy from a qualified retirement plan by making a payment to the plan equal to the cash value of the policy. The swap-out is neither taxable nor reportable.

Here are the facts of the case. A long-term client approached his advisor with a dilemma. The client, a dentist who recently sold his practice, had a large whole-life insurance policy within the business’s qualified retirement plan. The client wanted to maintain the policy because he was no longer insurable due to a recent medical condition.

While in the qualified retirement plan, policy premiums were paid from ongoing employer plan contributions; however, because the practice was sold, no additional contributions would be made to the plan. The client would have ample non-plan assets to make premium payments if he were allowed to hold the policy outside of the plan. His goal, however, is to avoid additional tax liability once the policy is removed from the plan.

Generally, when an insurance policy is distributed from a plan, the plan administrator reports the cash value of the policy as taxable income on IRS Form 1099-R, Distributions From Pensions, Annuities, Retirement or Profit-Sharing Plans, IRAs, Insurance Contracts, etc. However, DOL Prohibited Transaction Class Exemption 92-6 (PTE 92-6) permits a plan to sell a policy to the insured participant for its cash surrender value without taxation and without creating a prohibited transaction under the Employee Retirement Income Security Act of 1974 (ERISA) §406, or IRC §4975, provided the plan would otherwise surrender the policy. Thus, a plan participant may exchange or swap out the policy from the plan by making a payment to the plan equal to the cash value of the policy. In effect, the participant would give the plan a check for the cash value of the policy, and the plan would change the policy owner from the plan to the participant. The cash paid into the plan is placed in the participant’s account.

This type of exchange or swap out is not a taxable transaction and is not reported on IRS Form 1099-R. Once the policy is outside of the plan, premiums can be paid from other, non-plan financial resources.

Conclusion

DOL PTE 92-6 allows a plan participant to receive a life insurance policy from a qualified retirement plan by making a payment to the plan equal to the cash value of the policy. The swap-out is neither taxable nor reportable.