How to Buy Life Insurance Inside Your Retirement Plan

Retirement Daily contributor Joe Stenken explains why purchasing life insurance with premiums using before-tax money provides a substantial cost advantage over life insurance purchased outside of a retirement plan.
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By Joseph Stenken, J.D.

When most people think of investments to use in a qualified retirement plan, they generally think of mutual funds or individual stocks. What many people may not realize is that it is also possible to use retirement plan assets to purchase life insurance inside a retirement plan.

Joe Stenken

Joseph Stenken, J.D.

The ability to purchase life insurance with premiums that are paid with before-tax money provides for a substantial cost advantage over life insurance that is purchased outside of a retirement plan.

There are a number of reasons to purchase life insurance policy inside a retirement plan. The owners or employees may have unmet insurance needs. There may be gaps in the other employer-provided death benefit plans. Under certain conditions using life insurance in the retirement plan can lead to a larger contribution and therefore a larger deduction for an employer’s contribution to the retirement plan. Purchasing life insurance can also provide diversification within the investments of the retirement plan.

Certain life insurance products can help the employer ensure the costs of the plan will be more predictable. Life insurance can also provide benefits that are guaranteed by the insurance company. In addition to providing deductions from income, a significant portion of the life insurance death benefits are paid out income-tax free, while distributions from other investments within a retirement plan are taxable to the participant or beneficiary. Finally, certain types of retirement plans with life insurance are exempt from some Internal Revenue Service (IRS) funding rules that apply to other retirement plans.

There are limits on how much life insurance can be used in a retirement plan. The benefits from a life insurance must be “incidental” to other retirement benefits in the plan. The IRS has developed two tests to determine if the benefits are incidental. One test is whether the participant’s death benefit is less than 100 times the expected monthly retirement plan benefit. The second test requires that the total premiums paid must be less than a certain percentage of the entire plan cost for a particular participant. The percentage is 25 percent for term and universal life policies and 50 percent for “ordinary” life, more popularly known as whole life. If either of these tests is met, the life insurance is considered incidental.

Life insurance can be in both defined contribution plans, such as 401(k) plans, and defined benefit plans, such as cash balance plans.

While the life insurance is owned by the retirement plan, the insured participant will be taxed on the value of life insurance coverage. This value is based on what the premium would be for a term policy of the same death benefit as the policy in the retirement plan. If the insured dies and a death benefit is paid while the policy is owned by the retirement plan, part of the death benefit will be taxable. The portion that would be taxable would be the amount that represents the cash value if the policy had been surrendered on the date of the participant’s death.

When the insurance is no longer needed in the retirement plan there are different ways it can be removed from the plan. If it is simply transferred to the insured participant it will be a taxable distribution and the participant will pay tax on the value of the policy when it is transferred. To avoid a taxable distribution, the policy can be bought by the participant with outside funds to replace the value of the policy in the retirement plan. Either way, once the policy is outside the retirement plan, the new owner/insured may use the policy to take distributions providing retirement income outside the retirement plan or maintain cash in the policy to maintain a higher death benefit. If these distributions from the policy are managed correctly, they will not be subject to income tax.

About the author: Joseph Stenken, J.D., CLU, ChFC

Joseph Stenken, J.D., CLU, ChFC is Qualified Plan Counsel at McHenry Advisers, which provides retirement actuarial, insurance, and plan administration services for qualified retirement plans.


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