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A SINKING LIFERAFT? IRS POKES HOLE IN 'PENSION RESCUE' PLANS

February 20, 2004

Marketers have pitched so-called "Pension Rescue" arrangements to well-off Iowans over the past few years. These arrangements promise tax deductions for life insurance purchases and low-tax or no-tax transfers of lots of wealth to the next generation.

HOW IT WAS SUPPOSED TO WORK:

In one variant, a taxpayer on a corporate board of directors would set up a "Keogh" profit-sharing plan for her directors fees. The contributions to the plan would be deductible. Additional funding would come from a tax-free rollover of an existing IRA into the Keogh plan. The plan would use its funds to buy life insurance with a "springing cash value" feature; the policy cash surrender value would be reduced to a very low amount by a big "surrender charge" that would disappear all at once at some point in the life of the policy.

Shortly before the expiration of the surrender charge, the plan would transfer the policy to the taxpayer, who would pay tax on the temporarily depressed cash surrender value. The taxpayer would then transfer the policy to her heirs, valuing the transfer at the depressed value for gift tax purposes. Then the surrender charge would disappear and the cash value would "spring" to life, providing large amount of net worth to the next generation.

The "secret" of these plans is the reduced cash surrender value. For many income tax and gift tax purposes, cash surrender value is used to measure the value of an insurance policy. By artificially lowering the cash value, these plans tried to enable the transfers of policies at very low income tax and gift tax cost.

THE IRS RESPONSE

The IRS last week took a series of actions against combinations of qualified retirement plans and life insurance that they considered abusive.

Rev. Proc. 2004-16 says that cash surrender value can only be used to measure the value of life insurance policies distributed from a qualified plan if the value was at least the sum of:

-Premiums paid and dividends credited, reduced by
-actual reasonable mortality charges.

Rev. Proc. 2004-16 is effective February 13, 2004, so there is no "grandfathering" of existing "Pension Rescue" plans. This could lead to some unpleasant income tax and gift tax results.

USE INSURANCE WISELY

There are many important tax and financial uses for life insurance. An established insurance broker for a major insurance company can help you use the right insurance tools to meet your financial and tax goals. Beware the out-of-town salesman with a plan that seems too good to be true - it probably is.

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