Life Insurance in a Qualified Plan
Life insurance can be used as a funding vehicle for qualified retirement plans in one of two ways. First, life insurance or annuity contracts can be used exclusively to fund qualified plans known as "exempt fully insured plans," or Section 412(i) plans. "Exempt" means the plan is exempt from the minimum funding requirements established by tax law for qualified pension plans.
All contributions to the plan must be used to purchase life insurance policies or annuity contracts for the express purpose of accumulating retirement funds. Life insurance policy values can be accessed through loans and withdrawals. Exempt fully insured plans are used in defined benefit plan situations, especially when the employer wants to provide a pre-retirement death benefit as part of the plan.
The second way life insurance is used is in split-funded plans, where part of the retirement benefits are funded through life insurance, and part of the retirement benefits are funded through an investment account. Any life insurance provided by a split-funded plan must be available to the participants on a nondiscriminatory basis.
Life insurance must be "incidental" to the main retirement purpose of the plan, so there are limits on the amount of life insurance that can be purchased on behalf of a plan participant. These rules are different for defined benefit plans and defined contribution plans. Under a defined benefit plan, the face amount of insurance generally cannot exceed 100 times the participant's projected monthly retirement benefit.
Example: If the projected monthly retirement benefit were $4,000, the limit on the life insurance that could be provided would be $400,000. Coverage in excess of this amount would not be deemed "incidental."
An IRS revenue ruling (74-307) recognized an alternate test: Total premiums paid for term or universal life insurance must be less than 33-1/3 percent of the "assumed aggregate contributions" made on behalf of the plan participant from his matriculation in the plan. For ordinary whole life insurance, the figure is 66-2/3 percent. Under a defined contribution plan (including 401(k) and 403(b) plans), life insurance coverage can be provided if less than 50 percent of the employer's total annual contribution on behalf of the participant is allocated to the purchase of ordinary whole life insurance. The figure is 25 percent in the case of term or universal life insurance.
If both categories of policies are purchased inside the plan, then the sum of 50 percent of the ordinary life premium plus 100 percent of the term or universal life premium must add up to less than 25 percent of the employer's total annual contribution for the participant.
In a defined contribution plan, there is no limit on the face amount that can be provided. Providing life insurance inside a qualified retirement plan can be an inexpensive way to provide insurance protection for family members, while freeing up disposable income that might otherwise be used for insurance premiums.
If the insurance is payable to the participant's beneficiary or estate, the participant must report as gross income each year the value of the economic benefit provided by the "pure insurance" portion (death proceeds minus cash value) of the coverage. On the plus side, the pure insurance portion passes income tax-free to beneficiaries at the participant's death.
The taxable costs reported by the participant become part of his or her cost basis in the retirement plan, and may be recovered income tax-free when distributions are received.