Life Insurance in a Qualified Retirement Plan

While life insurance cannot be owned in a SEP or IRA, IRS regulations do allow the inclusion of life insurance policies in some profit sharing and defined benefit plans. These plans tend to be complex to administer and need to adhere to strict rules that require the life insurance protection provided be only “incidental” to the retirement benefits provided by the plan.

Using life insurance in a qualified plan does offer several advantages including:

• The ability to use pre-tax dollars to pay premiums that would otherwise not be tax deductible.
• Fully funding the retirement benefit at the premature death of the plan participant.
• Providing an income tax-free death benefit to the policy beneficiaries.
• Asset protection since an ERISA plan is generally protected from creditors.

However there also some negatives:

• The life insurance policy can only be held in the plan while the insured is a participant and unwinding the insurance at retirement or if the plan terminated can be complex.
• The business needs to have a qualified plan that allows for life insurance. These plans tend to be costly to set up, require annual reporting and on-going administration
• Plans must abide by ERISA rules that require all eligible employees to be included, the plan does not discriminate in favor of certain participants, and related businesses must be aggregated. The rules do allow placing limits on the amount of life insurance that is allowed for each participant, for example, five times the expected annual retirement benefit. Further, the plan trustee has some discretion in deciding what kind of insurance to include in the plan.

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 a participant's account for a minimum of two years are considered seasoned (although plans can have longer seasoning periods). However, all contributions become seasoned once the participant's account 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 have a different requirement in which the life insurance must be incidental, and the death benefit can be no greater than one hundred times that participants expected monthly retirement benefit. Although, in Section 412(i) plans, which are defined benefit plans that often use an annuity or life insurance to fund the retirement benefit, the amount of qualified money that can be used to pay life insurance premiums may be higher than for other defined benefit plans.

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 the insured dies prematurely the beneficiaries of the life insurance policy receive the death benefit, less any cash value in the policy, income tax-free. Any taxable economic benefit paid by the participant while 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 estate for state and federal estate tax calculations.

Upon retirement or if the plan were terminated there are several options in regards to the life insurance policy in the plan. With 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 income and estate tax-free.

Transfer ownership of the policy to the insured. The policy cash value would have to be recognized as taxable income in the year of the distribution and if the insured were under age fifty-nine and a half penalties may apply.

Surrender the policy and the cash value would remain in the qualified plan. However, this means the insured in giving up the life insurance coverage.

The policy can be sold to the insured or a grantor trust established by the insured. As long as the policy is sold for a fair market value there is no immediate income tax liability. This allows the insured to maintain the coverage. Once the policy is out of the qualified plan the insured can make any changes they desire to the coverage to meet their retirement and estate planning needs. There are, however, special rules that dictate what members of a family who own more the 50% of a business can do when buying a life insurance policy from the pension plan.

Having the opportunity to pay life insurance premiums with pre-tax dollars is appealing. However, the additional costs and complexity of meeting all the requirements may outweigh the benefits. An individual policy may be easier to manage and offer more flexibility in deciding what kind and how much coverage to own.