Using Life Insurance in Qualified Plans

Qualified retirement plans, such as 401(k)s or profit-sharing plans, are designed primarily to provide income for an individual’s post-employment years. Under specific Internal Revenue Service (IRS) regulations, these plans are permitted to include life insurance policies as an asset. The governing plan document for the specific retirement plan must explicitly authorize the purchase of life insurance.

Federal rules are in place to ensure that the primary focus of the plan remains on providing retirement benefits, not death benefits. These regulations dictate how much insurance can be purchased, the tax consequences for the plan participant, and how the policy and its proceeds are treated upon death, retirement, or separation from service.

The Incidental Benefit Rule

The ability to hold life insurance in a qualified plan is governed by the incidental benefit rule. This rule, outlined in Treasury Regulation §1.401, ensures that life insurance remains a secondary feature of the plan, subordinate to its main purpose of providing retirement income. The IRS has established specific quantitative tests to determine if the amount of insurance is incidental, and the applicable test depends on the type of retirement plan.

For defined contribution plans, such as 401(k) and profit-sharing plans, the tests are based on the percentage of employer contributions used to pay policy premiums. If the plan purchases whole life insurance, the aggregate premiums paid cannot exceed 50% of the cumulative employer contributions and forfeitures. For term or universal life insurance, the limit is stricter, with premiums not to exceed 25% of employer contributions and forfeitures.

A different standard applies to defined benefit plans. The most common measure is the “100-to-1 test,” which states that the life insurance death benefit cannot be more than 100 times the participant’s projected monthly pension. For instance, if a participant is projected to receive a monthly pension of $4,000, the plan could provide a death benefit of up to $400,000.

An exception exists for certain profit-sharing plans related to “seasoned money.” Funds that have been in a participant’s account for at least two years, along with funds in the account of a participant with at least five years of plan participation, may be used to purchase life insurance without regard to the 25% or 50% premium limits.

Tax Treatment of Premiums and Proceeds

When a qualified plan pays premiums for a life insurance policy, the participant must recognize and pay income tax on the value of the pure life insurance protection they receive each year. This taxable amount is the “economic benefit” of the coverage, calculated using rates from an IRS schedule known as Table 2001. The calculation involves taking the total death benefit, subtracting the policy’s cash value at the end of the year, and applying the Table 2001 rate corresponding to the participant’s age. This taxable economic benefit creates a cost basis for the participant in the policy.

The tax treatment of the death benefit paid to a beneficiary is a two-part calculation. The portion of the proceeds equal to the policy’s cash surrender value at the time of death is treated as a distribution from the qualified plan. This amount is generally taxable as ordinary income to the beneficiary but is reduced by the participant’s cumulative cost basis.

The remaining portion of the death benefit, known as the “net amount at risk,” is the pure insurance element. This amount is received by the beneficiaries completely free of federal income tax. For example, if a policy with a $500,000 death benefit has a cash value of $100,000 at death, and the participant had a cumulative cost basis of $15,000, the beneficiary would receive $400,000 income-tax-free. The remaining $100,000 cash value portion would be subject to income tax, but only on the $85,000 that exceeds the participant’s cost basis.

Handling the Policy at Retirement or Separation from Service

When a participant with a life insurance policy retires or leaves a job, a decision must be made about the policy’s future, as it cannot remain in the plan. One option is for the plan to distribute the policy directly to the participant. This transfer is a taxable event, and the policy’s fair market value is considered part of the participant’s retirement distribution. To avoid an immediate tax liability, the participant can roll over the policy’s value into an Individual Retirement Account (IRA), but since IRAs are prohibited from holding life insurance under IRC §408, the policy itself cannot be rolled over.

Another strategy is for the plan to sell the policy to the participant for its fair market value. This sale allows the participant to acquire the policy, and the cash proceeds from the sale remain within their retirement account, preserving the tax-deferred status of those funds.

A third option is for the plan trustee to surrender the policy to the insurance carrier. The insurance company pays the policy’s cash surrender value, and these funds are deposited into the participant’s retirement plan account, which terminates the life insurance coverage.

Plan Types and Insurance Suitability

While permissible in many qualified plans, life insurance is more practically suited to some designs than others. Profit-sharing plans are often considered a good fit because the flexibility of employer contributions makes it easier to manage the fixed obligation of paying insurance premiums.

Defined contribution plans that are not profit-sharing plans, such as standard 401(k)s, are less common vehicles for life insurance. Using an employee’s own 401(k) deferrals to pay premiums can be administratively complex and may conflict with the goal of maximizing retirement savings.

Defined benefit plans can be particularly well-suited for incorporating life insurance, especially for business owners and key executives. The predictable funding obligations of these plans can more easily accommodate the fixed cost of insurance premiums. Other plan types, such as Employee Stock Ownership Plans (ESOPs) and 403(b) plans, may also permit life insurance, but it is generally less frequent.