Life insurance can be purchased safely with pre-tax dollars in retirement plans.

Imagine the goodwill and loyalty you would engender if a client saved $48,000 a year on a tip from you. No, not a stock tip--a tip on converting a whole life insurance policy to a universal life policy.

This is just one of the recent developments in the life insurance industry that we discussed recently with Dr. Lee Slavutin of Stern Slavutin 2, Inc., a New York City insurance planning firm.

Universal Life and Conversions

The newest generation of universal life policies provides permanent insurance with a relatively low premium. For example, one 70-year-old woman who paid an annual $71,000 premium on a $4.9 million whole life policy converted it to a universal life policy and reduced the annual premium to $23,000--a savings of $48,000! That premium was locked-in for her lifetime. With conversions comes one caveat, however: the premium for many of these new universal life policies must be paid on or before the due date, without exception. Otherwise, the duration of the guaranteed death benefit may be reduced.

When a client is considering the purchase of a term life policy, suggest that he or she first examine the policy's conversion option. A policyholder wants an option that allows conversion at any time for the full period of the policy to any type of permanent insurance offered by the insurer--whole, universal or variable life--without having to prove insurability.

Split Dollar Life Insurance

Although split dollar life insurance plans were severely curtailed by the final income tax regulations in 2003, one plan that is still viable is endorsement split dollar in which the corporation owns the policy and endorses the death benefit to the insured employee's beneficiary or trust. The corporation pays the premium and the employee reimburses the corporation for a small fraction of the premium. For example, a 45-year-old executive was insured for $1 million. His company paid the $20,000 annual premium; he contributed $590. If the employee dies before retirement, the employee's beneficiary receives the tax-free death benefit less the cash value (or cumulative premiums paid by the corporation, if greater). When the employee retires, he can buy the policy from the corporation or receive it as taxable compensation.

Welfare Benefit Trusts

Welfare benefit trusts funded with permanent life insurance were promoted as a way to buy insurance on a tax-deductible basis. As you would with other aggressive insurance tax plans, view this one with caution. IRS Notice 2004-67 treats this as a "Listed Transaction" for tax shelter purposes, and the American Jobs Creation Act of 2004 requires material advisors to file information returns with respect to reportable transactions.

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Another questionable transaction involves charities that have an insurable interest in the insured individuals as well as non-charitable participants who have no relationship to the insured. The Treasury Department, in its recent 2006 Budget Proposal, wants to impose a 25 percent excise tax on the proceeds of such policies.

Spending Pre-tax Dollars on Life Insurance

Life insurance can be purchased safely with pre-tax dollars in retirement plans. Fully insured plans (Code section 412[i]) invest all the plan assets in a combination of annuities and life insurance policies, or just annuities. They allow for substantial tax deductions in some cases. A 56-year-old doctor earning $600,000 annually could contribute $242,000 to such a plan in one year. The allowable contributions typically go down over time, but this is still an attractive way to fund retirement savings and get a tax break.

However, don't go too far with that solution. Variants of those plans involve the purchase of excessive amounts of insurance, and such transactions are on the same list as the welfare benefit trusts already mentioned. The IRS has provided clear guidance on this (Revenue Rulings 2004-20 and 2004-21).

Mr. Kess is the author of 25 books on tax related topics. He is probably best known for lecturing to more than 45 State societies and more than 700,000 practitioners on tax and estate planning issues. In 2003 he received special recognition from the AICPA and CCH for his many contributions to the tax profession. He created and moderates the annual AICPA Conference on Tax Strategies for the High-Income Individual. He is a graduate of Harvard Law School and received his L.L.M. from New York University.