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Benefits of Employees Purchasing Life Insurance in Qualified Plans

When looking at Life Insurance in Qualified Plans there are many differences, benefits, and goals with each type. The following wiill detail how it works, its limits, Plan Provisions and more. Please feel free to contact us if you ever have any questions regarding how it could work for you or your business. 

Basics – How Life Insurance Works in a Qualified Plan

All profit sharing/401K qualified plans may allow for the purchase of life insurance on a tax favorable basis using deductible employee (EE) and/or employer (ER) contributions as the premium source. Here are some ways Life Insurance works within these plans:

  • EE/ER contributions are used to pay premiums and are tax deductible.
  • EE (participants) may be able to use some of their existing 401K plan account value to pay for their insurance in the plan.
  • The EE's beneficiary receives the net death benefit (face amount less the policy cash values) income tax-free if: the EE dies while their insurance policy is still in the plan; and the EE pays income tax each year, for the economic benefit of life insurance provided in the plan.
  • Permanent life insurance purchased by the plan can be available to the EE after retirement.

Limits on Life Insurance in Qualified Plans:

When establishing a Profit Sharing/401K plan, there are limits as to how much of the contribution by the EE can be put towards the purchase of life insurance. The following rules should be considered when looking at your options:

  • 50% Rule for Whole Life: Up to 50% of employer contributions and salary deduction contributions can be used to buy whole life insurance in the first 2 years of participation in a profit sharing plan.
  • 25% Rule for Term and Universal Life (UL): Up to 25% of ER contributions and salary deduction contributions can be used to buy UL or term.
  • Seasoned Money (2-year rule): All funds that have been accumulated in an EE's account for more than 2 years may be used for life insurance.
  • Seasoned Money (5-Year Rule): If the EE has been in a plan for more than 5 years, then all of the funds in the EE's account can be used to buy life insurance.

Plan Provisions:

  • The application of the seasoned money rules is only available if the plan document allows “in-service” distributions.
    • Most qualified plan documents can be amended to accommodate the “in service” distributions requirement.
  • The qualified plan document must have suitable language authorizing the use of contributions and fund balances (self-directed) for the payment of premiums.
    • Most plan documents can be amended, or restated, to include these provisions.
    • The qualified plan is both the owner and beneficiary of these life insurance policies. The policy cash value is an asset of the plan and is used to fund retirement benefits while the “pure” death benefit (face amount less the policy cash value) is typically designated for the EE's (participant's) beneficiaries.
    • There is an "inputed income" tax due each year on the EE's tax return, for the "economic benefit" of the life insurance "pure" death benefit provided to the EE. If not properly accounted for, the EE's plan beneficiaries could be subject to ordinary income tax treatment on the distributed insurance death benefit in the event of the EE's death. 

Life Insurance Contracts in Qualified Plans at Retirement or Plan Distribution:

Virtually all Qualified Plans require that a life insurance policy cannot be held beyond retirement of the EE.

  • The Qualified Plan documents will control the distribution options available to retirees.
  • Since IRA's can't own life insurance contracts, rolling the participant's qualified plan into an IRA holding life insurance is not an option.

The following are some of the life insurance exit options available to insurance contracts in Qualified Plans:

1. Surrender the policy inside the plan: Cash values become part of the plan assets and are used to pay retirement benefits due.

  • Surrender cash value proceeds can be rolled into an IRA as part of the plan's other assets.

2. EE purchases policy from the qualified plan for fair market value: The amount paid to the plan for the purchase of the policy is combined with the EE/insured's investment account inside the plan as part of the general assets of the plan.

3. Plan distributes the policy to EE in lieu of retirement benefits: This is called a partial distribution of plan assets.

  • Please note that this is a taxable transaction, at ordinary income tax rates, and the ownership of the policy changes from the qualified plan to the EE/insured.
  • There is a 20% mandatory withholding on the taxable benefit. Payment of the 20% withholding can be accomplished by a distribution from the policy or using other qualified plan proceeds.

4. Apply a combination of 2 and 3: Equating to a partial purchase and partial distribution – having the net effect of reducing taxation and out of pocket costs to acquire the insurance from the qualified plan.

  • The IRS provides guidance on valuation of insurance contracts when purchasing or distributing the contract from the Qualified Plan to a new owner.
  • Alternatively, the insured may choose to order a formal valuation by a recognized valuation expert, specializing in insurance policy valuations.

If you have additional questions or would like to discuss this concenpt and how it may help you and/or your clients or employees, please feel free to contact us in your most convenient manner.

Notes: This information is general in scope and is not intended to cover all aspects of owning life insurance in qualified plans. Actual recommendations must be made with the input of qualified tax advisors and a formal review of all plan documents by the plan's Third Party Administrator.