Life and Death Planning for Retirement Benefits

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Life and Death Planning for Retirement Benefits

Difference Between “Basis” and “Investment in the Contract”

The Internal Revenue Code taxes “income.” When an individual sells or otherwise disposes

of property in exchange for consideration, the resulting “income” that is subject to taxation is

generally the gross consideration the individual receives minus the

cost

of the property, i.e., the

amount the individual originally paid to get that property plus whatever amounts he invested in

the property prior to disposing of it. When property is sold in a transaction taxable under

§ 61(a)(3) ,

the cost offset the taxpayer can deduct from the sale price to determine his gain is called his “basis.”

§ 1001(a) .

In the case of insurance products, however, a different approach applies. Amounts the

individual receives under the policy from the issuer are taxable under

§ 72 ,

not

§ 61 . § 72

allows

an offset for the individual’s “investment in the contract” rather than his “basis.” Reg

. § 1.72-6 .

Tax afficionados tend to treat the two terms as interchangeable, and assume that (however

the individual may dispose of the insurance policy, whether via surrendering it to the insurance

company or selling it to a third party), the individual’s gain would be measured the same way.

Rev. Rul. 2009-13, 2009-21 I.R.B. 1029, has exploded this notion, making it clear that a policy

holder’s “investment in the contract” (relevant for measuring income under

§ 72

if the policy

holder receives payments under the contract from the insurer) is not necessarily the same as his

“basis” (used for measuring gain if the policy is sold to a third party). In particular,

premiums paid

for current insurance protection

are included in “investment in the contract” but not in “basis.” So

the sale of a policy to a third party may generate taxable gain even if surrendering the same policy

in exchange for the same amount of money to the issuing insurer would not generate gain.

For what happens to the investment in the contract if the policy is sold to the beneficiaries,

see

¶ 11.3.06 ;

on the participant’s death, see

¶ 11.2.06 .

11.2.06

Income tax consequences to beneficiaries

Normally, life insurance proceeds are income tax-free to the policy beneficiaries

. § 101(a) .

However, when proceeds of

plan-owned

life insurance are paid to the beneficiaries

, § 72(m)(3)(C)

dictates that, to the extent of the policy’s cash surrender value (CSV) immediately prior to the

participant’s death, the distribution is treated as a “retirement plan distribution” (taxable under

§ 402 )

rather than as a tax-free distribution of “life insurance proceeds.” Thus, to the extent of the

pre-death CSV, life insurance proceeds are treated the same as all other retirement plan

distributions, and are subject to income tax when paid out to the beneficiaries. Only the “pure

insurance protection” portion of the distribution is tax-exempt unde

r § 101(a) .

Despite the fact that the participant might have been taxable on

more

than the CSV if the

policy had been distributed to him during life (see

¶ 11.3.02 )

, only the CSV is treated as gross

income to the beneficiaries. Also, the beneficiaries are entitled to deduct the amount of the

participant’s investment in the contract

( ¶ 11.2.05 )

from the amount otherwise includible in their

gross income. See Reg.

§ 1.72-16(c)(3) ,

Example 1; Rev. Rul. 63-76, 1963-1 C.B. 23.

11.3 Plan-Owned Life Insurance: The “Rollout” at Retirement

If the participant does not die while still employed, he must make some choices regarding

the life insurance policy when he retires.

11.3.01

Options for the policy when the participant retires