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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 Georgia is representative of a common question on valuing a life insurance contract distributed from a 401(k) plan.
When a 401(k) plan distributes a life insurance policy, the receiving participant must include the “fair market value” of the policy in income for the year [Treas. Reg. § 1.402(a)-1(a)(1)(iii) and (a)(2)]. The fair market value, however, is not necessarily the “cash value.” Fortunately, the IRS has provided safe harbor rules for determining the fair market value of life insurance policies upon distribution from a 401(k) plan in Revenue Procedure (Rev. Proc.) 2005-25.
The IRS issued Rev. Proc. 2005-25 primarily to address the issue of a “springing cash value plan,” a policy in which, for the first few years, the cash surrender value of the policy is much lower than the value of the premiums paid or the reserve accumulations (see the Internal Revenue Manual 4.72.8.5.3).
Under the first safe harbor, for non-variable contracts, a plan may measure the fair market value as the greater of either:
The sum of the interpolated terminal reserve and any unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year based on company experience, or
The product of the PERC (Premiums, plus Earnings, minus Reasonable Charges) amount and applicable Average Surrender Factor. (See Section 3.02 of Rev. Proc. 2005-25 for details).
Under the second safe harbor, for variable contracts, the fair market value of an insurance contract is the greater of:
The sum of the interpolated terminal reserve and any unearned premiums plus a pro rata portion of a reasonable estimate of dividends expected to be paid for that policy year, or
The product of the variable PERC amount and the applicable Average Surrender Factor. (See Section 3.03 of Rev. Proc. 2005-25 for details).
The use of either of these safe harbor definitions will meet the definition of “fair market value” for purposes of Internal Revenue Code sections (IRC§§) 79, 83, 402(a), and 402(b), as well as the definition of “vested accrued benefit” for purposes of IRC §402(b)(4)(A). Plan sponsors should ensure providers of life insurance contracts and plan record keepers are following the guidance of Rev. Proc. 2005-25 when determining the fair market value of a distributed life insurance contract.
Conclusion
When a 401(k) plan distributes a life insurance policy, the receiving participant must include the fair market value of the policy in income. The IRS provides safe harbor valuation methodologies in Rev. Proc. 2005-25. Although they are not the only approaches a plan could use, these safe harbors give plan sponsors the comfort of knowing the IRS will not likely challenge them.