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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.

Key Takeaways

  • Having the opportunity to pay life insurance premiums with pre-tax dollars is appealing, but the 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.
  • Qualified retirement plans that allow life insurance are defined contribution plans and defined benefit plans.
  • If the plan is terminated early or the participant retires, the remaining balance can be rolled over into an IRA.

Advantages and Disadvantages

Cash-Value Life Insurance

Plans That Allow Life Insurance

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 participant’s 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.

Tax Issues

If you retire or the plan is terminated, the policy can be bought and transferred to an irrevocable life insurance trust, transferred to the insured, surrendered, with the remaining cash value left in the plan, or sold to the insured or a grantor trust established by the insured.

Exit Strategies

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 59-1/2 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 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 than 50% of a business can do when buying a life insurance policy from the pension plan.

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About Amy Harvey

Amy R. Harvey writes forStartUps Sections In AmericaRichest.

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