What is Pension Income Supplemental Life Insurance?
The use of life insurance as a supplement to retirement income is an alternative to the company-provided survivor income options. It involves a two-step procedure that combines a life income option annuity election with life insurance on the retiring worker’s life. By electing the full annuity benefit from a retirement plan, the worker receives the maximum monthly retirement benefit for life.
Pension income supplemental life insurance can also help provide added flexibility and other benefits to the couple. However, it is usually not appropriate if the retiree is in poor health.
Why a Married Retiree Should Use Pension Income Supplemental Life Insurance
Every married retiree who participates in a retirement plan will be faced with an important economic decision. At or before retirement, every worker should decide how to arrange his or her payout. It’s not an easy decision: Whether to choose all the monthly income to which the worker is entitled by electing a life income option, or settling for what can be a hefty cut in benefits to provide a retirement income for the surviving spouse. What makes the decision even more difficult is this decision is often irrevocable after retirement begins. Note, however, that this income preservation approach is usually not appropriate for an employee close to retirement, or when the retirement plan provides an inflation-indexed payout.
It is imperative that workers consider and calculate the impact of the tax law rules on themselves and their spouses before making a supplemental retirement payout decision, preferably with the assistance of a tax advisor.
Current law requires that a pension plan subject to ERISA automatically provide a participating retiree with a qualified joint-and-survivor-ship annuity as a payout option. This annuity must provide:
Or, if the spouse consents in writing to a waiver of the worker’s survivorship benefits, the retiree can choose to take the maximum monthly benefit available.
It’s not an easy decision and it’s compounded by the fact that the couple faces twin risks:
(1) If the couple chooses the survivorship annuity, this can result in a substantial decrease in the monthly benefit paid to the retiring worker. If the spouse dies first, the survivor benefit will never be paid (although some plans do offer a so-called “pop-up” provision which increases the worker’s benefit if the spouse dies first, there is still no recovery of the amount that was lost during the spouse’s life). Also, if the retiree then remarries, there is no benefit for the new spouse—the reduced supplemental retirement income payments will continue for life. Therefore, choosing the survivorship annuity often means settling for quite a bit less in order to provide for a contingency that might not even happen (namely, the retiree dying before the spouse).
(2) If the couple waives the survivorship annuity, they enjoy the full monthly retirement benefit as long as the retiree lives. However, if the retiree does die first, benefit payments stop, and the spouse could be left with little security during retirement.
The amount of the reduction depends on the age of both the worker and the spouse. The younger the spouse, the greater the reduction.
For illustrative purposes, let’s assume that, in order to elect a joint and equal survivor benefit—where the same monthly payment continues to a surviving spouse—a worker might receive 75% of what would otherwise be available under a life income option. The table that follows shows what that cost could amount to over a period of time.
Dollar Loss in a Joint-and-Equal-Survivor Benefit
|$ 500||$125||$1,500||$15,000||$ 30,000|
Under these assumptions, a worker who might otherwise receive a $1,500 maximum monthly benefit could be faced with a monthly loss of $375 if he or she elected a joint-and-survivor benefit. This translates into a $45,000 loss over 10 years and a $90,000 loss over a 20-year period.
The cost is obvious, and the decision is irrevocable. Within 90 days of when benefits are to begin, the worker must make an election. Absent formal action, the survivorship election is automatic. After benefits begin, the election is irrevocable except in those few plans with a “pop-up” provision. Therefore before workers elect less than the full life annuity benefit or let the government make the election for them, they should consider the consequences.
Alternatives are available to provide more retirement income. The retiree may be better off purchasing a life insurance policy which would provide the worker and surviving spouse with a benefit equal to the maximum benefit. It’s a two-step procedure that can result in greater supplemental retirement income for married workers and their spouses. Of course, the worker must be able to qualify for life insurance.
Step one: The worker buys a life insurance policy on his or her life and names the spouse beneficiary. (A worker whose health is not good may not be able to obtain insurance, or may find that it is very costly.) The plan is designed so the proceeds from the life insurance are used to create a fund that will pay a lifetime supplemental income to the spouse which is equal to the pension benefit should the spouse survive the retiree. The death benefit can be structured to create a capital account. Earnings are withdrawn from the account and paid to the surviving spouse, or the plan could be structured so that a settlement option provides supplemental lifetime income to the surviving spouse.
Step two: Once the policy is issued, the worker usually elects the life income option from the retirement plan. The payments end when the worker dies.
Pension income supplemental life insurance can also offer attractive additional benefits:
(1) Life insurance provides extraordinary flexibility. If the spouse dies first, the policy can be surrendered and the retiree can use the cash surrender value to supplement retirement income. Or the policy may be continued for the benefit of surviving family members.
(2) Policy cash values accumulate on a tax-deferred basis.
(3) Retirees who remarry can use the life insurance to help provide benefits to a new spouse.
(4) The surviving spouse has maximum control over the insurance proceeds. Life insurance proceeds can be used to help meet a wide variety of income and planning needs. And benefits can be received as a single, tax-free lump sum or through a variety of settlement options.
Payments made to retired workers are fully taxable when all contributions to the plan have been made by the employer. Insurance policy death benefits paid as a lump sum, on the other hand, are not taxable as income to the beneficiary. Generally, the interest earned on proceeds held by the insurer under a settlement option is taxable as it’s received.
Death benefits taken over a period of time as an annuity are taxable only to the extent that an annuity payment is deemed to represent income. A certain portion of each payment is considered a return of capital. The taxable portion of each payment is calculated by applying an appropriate exclusion ratio. This ratio reflects the portion of yearly annuity payments that can be excluded from gross income.
Pension income supplemental life insurance may offer the best of both worlds—
That can translate into higher supplemental retirement income for both spouses for as long as they live.
Who should consider this two-step plan to greater supplemental retirement income? It is best suited for healthy people in their forties or fifties who are married and who are currently employed and covered by a company pension . . . or any prospect or client who is concerned about providing retirement income for self and spouse.
A plan for pension income supplemental life insurance may:
If the costs of insurance are not paid, and the insurance lapses, the spouse will lose the supplemental income intended by the arrangement.
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