It is possible to buy life insurance through some qualified retirement plans, like a 401(k) or a pension. If you do so, you can pay for the coverage using pre-tax dollars. In other words, you save on taxes while buying life insurance.
These plans tend to be complex to administer and must follow strict rules for managing the life insurance policy. This strategy if often used by business owners who control their company retirement plan and have the need for a large, expensive life insurance policy.
Key Takeaways
- You pay life insurance premiums with pre-tax dollars in a qualified retirement plan.
- Defined contribution plans and defined benefit plans are options that allow life insurance.
- If your plan is terminated early or you retire, the remaining balance can be rolled over into an IRA.
- This strategy must meet complex regulatory requirements and can be expensive.
- An individual policy may be easier to manage and offer you more flexibility to design coverage.
Advantages and Disadvantages
Buying life insurance in a qualified retirement plan does offer several advantages, including:
- The ability to use pre-tax dollars to pay premiums that would otherwise not be tax-deductible.
- The option to pay for the insurance using your existing retirement plan savings.
- Fully funding your retirement benefit if you die while working.
- Providing an income-tax-free death benefit to your policy beneficiaries.
- Asset protection, as an Employee Retirement Income Security Act (ERISA) plan is generally protected from creditors.
However, there are also some disadvantages:
- The life insurance policy can only be held in the plan while you are a participant.
- It can be complex to unwind the insurance when you retire or if the plan is terminated.
- The organization sponsoring the plan needs to offer a qualified plan that allows for life insurance. These plans tend to be costly to set up and require annual reporting and ongoing administration. Lower-cost retirement plans, like an IRA or a simplified employee pension, do not allow life insurance.
- Plans must abide by ERISA rules that require all eligible employees to be included. The plan cannot discriminate in favor of certain participants, such as only offering benefits to the business owner and key executives.
Rules for Life Insurance in Qualified Retirement Plans
Defined-Contribution Plans
In a defined-contribution plan, if a whole life policy is purchased, the premium must be less than 50% of the contributions made to the plan. If a universal life policy is used, the premium paid must be less than 25% of plan contributions. A special rule also applies to profit-sharing plans if seasoned money is used to pay the life insurance premium.
Contributions that have accumulated in your account for a minimum of two years are considered seasoned (although some plans can have longer seasoning periods). However, all contributions become seasoned once youraccount is at least five-years-old.
If the plan allows only seasoned money to be used to pay the insurance premiums, then the percentage limits for defined contribution plans no longer apply. However, the limits do apply if a mix of non-seasoned and seasoned contributions are used.
Defined-Benefit Plans
Defined-benefit pension plans have a different requirement that the life insurance must be incidental. In addition, and your death benefit can be no greater than one hundred times your expected monthly retirement benefit.
However, the IRS has additional rules for Section 412(e)(3) plans (which are defined-benefit plans that often use an annuity or life insurance to fund the retirement benefit). For these plans, the amount of qualified money that can be used to pay life insurance premiums may be higher than that for other defined-benefit plans.
Tax Issues
When life insurance is purchased in a qualified account, the premium is paid with pretax dollars. Consequently, the participant must recognize the economic benefit received as taxable income.
The amount recognized varies each year and is calculated by subtracting the cash value from the policy death benefit. The taxable value (economic benefit) of the insurance received is determined by using the lower of the IRS Table 2001 cost or the life insurance company’s cost for an individual, standard rated one-year term policy.
If you retire or the plan you participated in is terminated, you have several options. The policy can be bought and transferred to an irrevocable life insurance trust, transferred to the insured, surrendered with the remaining cash value left in the plan, or sold to the insured or a grantor trust established by the insured.
If you die prematurely, your beneficiaries receive the death benefit (less any cash value in the policy) free of income taxes. Any taxable economic benefit paid by the participant while you are still alive can be recovered tax-free from the cash value.
The remaining cash value can remain in the plan or be taxed as a qualified plan distribution. However, any death benefit paid from a policy in a qualified plan is included in the decedent’s estatefor state and federal estate tax calculations.
Exit Strategies
If you retire or the plan is terminated, there are several alternatives to handling the life insurance policy in the plan. Under any of these options, the remaining value in the qualified plan could then be rolled over to an IRA.
- The policy could be purchased by and transferred to an irrevocable life insurance trust. If properly structured, the death benefit will remain free of income and estate taxes.
- Transfer ownership of the policy to the insured (you). The policy cash value would have to be recognized as taxable income in the year of the distribution. If you are under age 59½, penalties may apply.
- Surrender the policy, leaving the cash value in the qualified plan. However, this means the insured is giving up the life insurance coverage.
- You can buy the policy or sell it to a grantor trust that you establish. As long as the policy is sold for fair market value, there is no immediate income tax liability. This approach allows you to maintain the coverage.
Once the policy is out of the qualified plan, you can make any desired changes to the coverage to meet your retirement and estate planning needs. There are, however, special rules that dictate what members of a family who own more than 50% of a business can do when buying a life insurance policy from the pension plan, so check with your financial advisor to determine the best choice.
Why Buy Life Insurance in a Qualified Retirement Plan?
Doing so permits buyers to use pre-tax dollars to pay premiums that would not otherwise be tax-deductible. If the plan participant dies prematurely, the retirement benefit is fully funded. This also provides an income-tax-free death benefit to your policy beneficiaries and provides asset protection from creditors.
What Are Some Downsides of Buying Life Insurance in a Qualified Retirement Plan?
For starters, the life insurance policy can only be held in the plan while the insured is a participant. Unwinding the insurance at retirement or if the plan is terminated can be complex. Also, the business needs to have a qualified plan that allows for life insurance, and these plans tend to be costly and complicated. Finally, plans must abide by ERISA rules that require all eligible employees to be included.
Is Life Insurance a Retirement Plan?
Life insurance is often referred to as a retirement plan due to the cash component of some life insurance policies that act as retirement income for individuals. However, life insurance should not be considered as a replacement to other traditional retirement plans, such as 401(k)s and IRAs. The rate of return is not as high as investing in the stock market.
The Bottom Line
It is possible to buy life insurance through some qualified retirement plans. Doing so allows you to pay the premiums with pre-tax dollars and your existing retirement funds. However, there are many strict rules you must adhere to. This makes the process difficult and expensive. In many cases, you may be better off simply purchasing an individual policy. Consult with an insurance and a retirement plan expert before moving forward with this strategy.
Correction—December 1, 2021: A previous version of this article referred to the 412(i) plan. The 412(i) plan was replaced by the 412(e)(3) plan in 2007.
