A qualified retirement plan may purchase life insurance to provide death benefits. Such a purchase must be authorized by the plan document but the decision to buy a policy may be made by either the plan administrator (employer) or the participant. In a Defined Contribution plan, the policy is part of the participant’s account. In a Defined Benefit plan, the death benefit is part of the definitely determinable benefit provided to the participant by the plan.

INCIDENTAL BENEFIT

The purchase of life insurance must be incidental to the primary purpose of providing retirement benefits under the plan. Under treasury regulations, this incidental benefit results in limits being placed on the amount of premiums paid as follows:

• Whole life – the total premium cost is less than 50% of the total contributions—401(k), employer match, employer profit sharing, and forfeitures, but excluding investment earnings
• Term or universal life – the total premium cost is less than 25% of the total contributions

Contributions that have been in the plan for two years or more may also be used to pay life insurance premiums. After-tax employee contributions and rollover contributions may be used to pay premiums and are not subject to the incidental rules.

Defined Benefit Pension plans usually use the 100x rule, which says insurance benefits are considered incidental if the face value is no more than 100 times the anticipated monthly annuity benefit provided by the plan. Because of this, most or all of the participants in the plan must have insurance policies.

TAXABLE PORTION OF PREMIUM – P.S. 58

The life insurance protection portion of the premium must be taken as a taxable benefit annually by the insured plan participant. This is called a P.S. 58 cost. The IRS has a table (Table 2001) outlining the determination of the insurance protection amount at a particular age. The formula is as follows: Face amount less cash value divided by $1,000 times the table factor. The insurer’s published rates may be used instead, but caution should be taken for policies issued after 2003. The P.S. 58 costs are basis in the participant’s account and are not taxed again when distributed to the participant or beneficiary unless the participant is a Self-Employed Individual.

DEATH BENEFIT PAYMENTS

Death benefits payable under the life insurance policy are considered “net proceeds” and excluded from gross income. Net insurance proceeds are calculated by taking the face amount of the policy less the cash value plus the accumulated P.S. 58 costs. For example, a policy with a $300,000 death benefit, $60,000 in cash value and $10,000 in accumulated P.S. 58 would result in a tax-free benefit of $250,000 to the beneficiary.

Death benefits are paid to the plan trustee and distributed to the beneficiary as part of the participant’s total benefit.

POLICY DISTRIBUTION OPTIONS

There are several options for a participant who separates from service with a life insurance policy held by the plan.

1. Take personal ownership of the policy. Transfer ownership from the plan to the participant. Under this option, the participant must either
   1. Repay the plan for the fair market value (cash value plus any “reserves”) of the policy.
   2. Take the cash value as a taxable distribution. Under this option, the 20% federal income tax withholding applies, so a portion of the account would have to be redeemed to cover this tax.
2. Rollover to a new employer plan. If allowed by the receiving plan, the participant could request a transfer of the insurance policy to their new employer’s plan.
3. Surrender the policy. If the contract is surrendered by the plan trustees, the policy proceeds will be included in the participant’s distribution. The P.S. 58 costs retain their character as basis for tax purposes.
4. Convert to annuity. The fair market value of a distributed life insurance contract can avoid income tax if it is converted within 60 days to a non-transferable annuity contract under which no life insurance proceeds would be payable upon the death of the insured.

PROS AND CONS OF INSURANCE IN QUALIFIED PLANS

PROS

• Access to insurance
  • Having an option to buy insurance with plan assets may be the only way some employees can afford insurance
  • Life insurance will protect the participant’s family in the event of premature death
  • Policies may be available on a guaranteed-issue basis even for participants who would be uninsurable on the open market
• Tax advantages
  • Having the majority of the insurance premiums paid with pre-tax dollars
  • Transferring the policy out of the plan to continue to enjoy the tax-deferred buildup of cash value outside of the plan

CONS

• Life insurance is inherently a tax-deferred vehicle—some would argue it doesn’t need to be provided in a tax-deferred qualified plan
• P.S. 58 costs are taxable each year causing additional burden on the plan sponsor to properly report and track
• The rate of return on a life insurance policy is not the same as alternative investments, so having insurance in the plan may reduce the participant’s overall retirement benefit

SUMMARY

Allowing for life insurance to be purchased within a qualified retirement plan may be valuable in certain circumstances. Offering this benefit within the plan requires additional administration by a company that understands the nature of the products. At Benefit Resources, Inc. we have significant experience working with insurance in qualified plans and we take the necessary steps to guide our clients who choose this option. We report the cash value on the participant statements. We compute, track and report P.S. 58 costs, and we offer options at termination or retirement for the disposition of the policy.