What Is IRS Section 72(m)(7) and How Does It Work?
Learn how the taxable cost of life insurance in a self-employed retirement plan can be recovered later to reduce the tax impact of future withdrawals.
Internal Revenue Code Section 72(m)(7) applies to self-employed individuals who hold life insurance within their qualified retirement plans. This rule allows the costs of pure life insurance coverage paid by the plan to be treated as a recoverable cost. This treatment establishes a “cost basis,” which reduces the taxable amount of future plan distributions. This allows the individual to recoup the previously taxed costs of the insurance protection.
Establishing Cost Basis from Life Insurance
In a retirement plan, “cost basis” represents the after-tax money a participant is considered to have contributed. When a qualified plan for a self-employed person uses assets to pay life insurance premiums, a portion of that premium is for pure insurance protection, not investment. The economic value of this coverage is a current benefit to the individual and must be included in their gross income for that year.
These taxed amounts are added to the participant’s cost basis in the plan. The IRS provides “Table 2001” to determine the value of this benefit, which reflects lower term insurance costs than historically used rates. Each year the plan pays the premium, the plan administrator calculates the value of the pure insurance coverage using Table 2001 and reports it as taxable income to the participant. This reported amount is then added to the cumulative cost basis, which grows over time as long as the policy is maintained.
Calculating Tax on Plan Distributions
The accumulated cost basis becomes relevant when the participant begins taking distributions from the retirement plan. The basis allows the participant to receive a portion of their distribution tax-free, as it represents a return of previously taxed funds. The total distribution is reduced by the recoverable cost basis, and only the remainder is subject to income tax.
For distributions taken before the “annuity starting date,” which is the date regular payments begin, the tax-free portion is determined on a pro-rata basis. This means the tax-free amount of any single withdrawal is proportional to the ratio of the total cost basis to the total account value. For example, if a participant has a cost basis of $20,000 and a total plan account value of $200,000, then 10% of any distribution would be a tax-free return of basis.
Once all distributions combined equal the total cost basis, any subsequent withdrawals are fully taxable. It is the responsibility of the plan participant to track this basis accurately. Plan administrators report the total distribution, but the participant must correctly report the taxable portion on their tax return by accounting for their basis.
Handling of the Life Insurance Policy
The tax treatment can vary depending on how the life insurance policy is handled within the plan. Different events can occur, each with its own set of rules for applying the accumulated cost basis.
Policy Surrender
If the life insurance policy is surrendered while held inside the retirement plan, its cash surrender value is added to the other assets of the plan. The accumulated cost basis from the term insurance costs is not lost. This basis remains with the participant’s overall account and can be used to reduce the taxable amount of subsequent cash distributions.
Policy Distribution
A participant may choose to have the entire life insurance policy distributed from the plan. The policy’s fair market value, which is its cash surrender value, is considered a taxable distribution. The participant can subtract their accumulated cost basis from this cash value to determine the taxable amount. If the policy is not rolled over into an IRA within 60 days, this taxable amount is included in the participant’s income.
Death Benefit Payout
If the participant dies while the policy is held in the plan, the tax consequences for the beneficiary are twofold. The portion of the death benefit equal to the policy’s cash surrender value is treated as a distribution from the retirement plan. The beneficiary can apply the decedent’s remaining cost basis against this amount to reduce the income tax due. The “pure insurance” amount, the total death benefit minus the cash surrender value, is received by the beneficiary income-tax-free.