Executive Summary
This memorandum outlines the method by which a closely-held business can implement a cash balance pension plan (“CBPP”) to benefit both employees and ownership. Particular attention is given to the use of the CBPP to purchase an indexed universal life (IUL) insurance policy on the business owner’s life, including the planned acquisition of the policy by the owner at its fair market value (FMV) in year five. The strategy offers significant income tax, retirement planning, and estate liquidity benefits, while also allowing for funding flexibility and a tax-efficient exit strategy from the plan.
I. Cash Balance Pension Plan Overview
A CBPP is a type of qualified plan under ERISA and the Internal Revenue Code (IRC), combining the predictability of defined contributions with the actuarial funding and benefits of a traditional pension. The defined benefit is stated in terms of a “cash balance” at termination vs a monthly benefit for traditional DB plans.
1. Business Income Tax Deduction
Contributions made by the business to the CBPP are fully deductible under IRC § 404(a)(1) based on the actuarially determined limit each year. These contributions reduce the business’s taxable income dollar for dollar and offer planning opportunities for high-income years.
2. Tax-Deferred Growth
Funds within the CBPP grow on a tax-deferred basis pursuant to IRC § 501(a), so long as the plan is qualified under IRC § 401(a). This allows investment growth without current taxation, similar to traditional retirement vehicles. Investments inside the plan are managed based on the risk tolerance of the business owner, goals for the plan, and compliance restrictions.
II. Structure of Accounts
401k Plan – can be used in combination with CBPP, but is not required
401k Match – will reduce the funding requirement for employees through the CBPP
Profit Share – defined contribution account where most of the employee funds are held
Pension Account – investment account with mostly owner funds
Insurance Policy – purchased by the CBPP to serve as a tax-efficient exit for funds
III. Life Insurance in the Plan
1. Permitted Use of Life Insurance
IRS guidance (Rev. Rul. 74-307; PLR 199901039) confirms that qualified plans may hold life insurance so long as it is incidental to the primary retirement purpose. This calculation is done by the actuary to ensure compliance. The CBPP will be owner and beneficiary of the policy, and if the insured dies, the cash value is retained by the plan, and the remainder of the death benefit is paid out tax-free to the insured’s family. Each year, the insured will receive a small 1099 based on this Economic Reportable Benefit.
2. Indexed Universal Life (IUL) Insurance Overview
IUL is a permanent form of insurance that has flexible premiums and cash value that can track a number of well-known equity indexes, such as the S&P 500 or NASDAQ 100 to earn interest credits. The policies have a 0% floor, meaning cash value can never be decreased based on market returns. On the upside, returns are limited based on a cap or participation rate.
3. Policy Structure
Pacific Life Horizon IUL is used for the favorable policy structure in relation to CBPP. By designing the policy to accelerate expenses in the first 5 years and delay credits based on following the 5-year S&P index, a temporary depressed fair market value (“FMV”) is created in year 5. This creates a favorable tax opportunity.
IV. Buying Out the Policy at Year Five
1. Fair Market Value Purchase
In year five, the plan participant (owner) or ILIT (Irrevocable Life Insurance Trust) may purchase the IUL policy from the CBPP at FMV. This transaction is governed by IRC § 83(a) and ERISA fiduciary standards. The FMV of the policy is typically determined using the PERC method (premiums + earnings – reasonable charges), per IRS guidance and case law (see Schwab v. Comm’r, T.C. Memo 1991-40; Cristo v. Comm’r, T.C. Memo 1992-274).
2. Tax Implications of Purchase
If the plan participant pays FMV for the policy, no taxable transfer occurs (Rev. Rul. 59-60; IRS Field Service Advice 200147003). The plan is compensated, and the participant receives the policy outside the plan without additional income recognition. The plan owner now owns a fully funded policy, which they were able to purchase at a substantial discount, creating a source of tax-free funds to use in the future.
V. Contributions in Favor of the Owner
Cash balance pension plans can be designed to favor business owners due to actuarial funding rules. The use of individual participant age and compensation profiles allows for disparity in contributions, which, in the case of a business owner, enables substantial funding while employees may receive a fraction of the allocation (Treas. Reg. § 1.401(a)(4)-3(f)).
VI. Contribution Flexibility and Overfunding
1. Flexible Contributions
CBPPs allow for flexibility in annual contributions within the funding range (minimum to maximum) as prescribed by the enrolled actuary under ERISA § 302 and IRC § 412(c)(7). If future income does not meet projections, the plan can potentially be adjusted to accommodate an increase or decrease.
2. Freezing Contributions
While temporary funding suspensions are possible, they must be carefully managed to avoid violating minimum funding requirements and nondiscrimination rules (see IRS Notice 96-8 and ERISA § 302(d)(9)).
VII. Plan Termination and Distribution
Plans are typically designed on a 10-year term. This can be adjusted to a shorter period if the business owner knows they will be selling or retiring before this period. Plans may also be terminated early and assets distributed if there is a valid business reason, including the scenario where a business can no longer support funding. IRC § 411(d)(3) and Treas. Reg. § 1.411(d)-2 provides for full vesting and distribution options such as annuity or lump sum rollover to an IRA.
Conclusion
For closely-held businesses, the CBPP structure allows the business owner to:
- Deduct high contributions annually,
- Use tax-deferred dollars to fund a life insurance policy,
- Acquire the policy personally at a fair value point that minimizes overall tax liability,
- Enjoy flexibility in funding and a clean exit on retirement or sale.
This strategy for your cash balance pension plan combines qualified retirement planning with long-term insurance and liquidity planning, yielding meaningful income tax savings while complying with IRC and ERISA guidelines.
