How To Use a Retirement Plan To Buy Life Insurance

By Jerry Kalish

Most business owners understand the need for life insurance, and, in today's economy, many have a problem finding the cash to pay for it. It might help them to be told that there’s a relatively little-known tax-planning technique that would allow you to use your profit-sharing/401(k) plan as a premium source to buy needed life insurance.

Why even consider the use of your profit-sharing plan/401(k) to buy life insurance?
The answer is simply that you can pay the premiums with tax-deductible dollars, and thus reduce your out-of-pocket cost.

What are the limits?
There are, of course, IRS rules regarding the value of life insurance that can be purchased in a qualified retirement plan, i.e., a defined-benefit plan or a defined-contribution plan such as a profit-sharing/401(k) plan. These limits are subject to what the IRS calls the “Incidental Death Benefit Rule”.

In the case of a defined-contribution plan, that rule limits:
* Whole life insurance premiums to no more than 49.99% of the contributions; or
* Term insurance and variable universal premiums to no more than 24.99% of premiums

There are three important exceptions that allow additional money to be used for premiums:
*100% of the account can be used if the participant was in the plan for at least five years.
*100% of the assets in the plan can be used if the assets were in the plan for at least three years.
*100% of rollover assets can be used.

This last exception can be extremely useful, since recent tax law changes made it easier to rollover accounts from prior employer plans and Individual Retirement Accounts. And there is no limit on the amount of these funds that can be used to pay for life insurance premiums.

Now, there are still some practical considerations. While up to 50% of the contribution can be used to purchase whole life insurance, it may not be a good idea to do so. Employer contributions to a profit -sharing plan are discretionary. If the employer has a bad year, there may not be enough contributions to pay the premiums.

Who Can Be Insured?
Generally, the only person who can be insured in a defined-benefit plan is the plan participant. However, in a profit-sharing plan, the insured can be a spouse, business partner, parents, or children. So profit-sharing plans are more flexible in this respect.

How is the benefit taxed?
The IRS considers the use of profit-sharing/401(k) dollars to pay for life insurance premiums to be an “economic benefit”--on which, yes, you will be taxed. The tax is based on the “one year term cost”. The IRS’s Table 2001 is what's used to calculate the tax. However, the insurance company’s one-year term rates can be used if they are made available to all standard risks.

What happens to the life insurance if the plan terminates, or once you are no longer covered by the plan?
There are several exit strategies that can be used to accomplish your personal objectives. The life insurance policy can be:
* Surrendered
* Annuitized
* Distributed
* Purchased

Each alternative has its own set of advantages, disadvantages, and tax consequences.

...Which is why you should discuss this matter with your tax advisor before you decide if using your profit-sharing/401(k) plan to pay for life insurance premiums fits your particular circumstances and objectives.

And finally, since retirement plans must be administered in accordance with a written plan document, make sure that your plan document specifically has the appropriate provisions to permit this.

Jerry Kalish is founder and President of National Benefit Services, Inc., a Chicago-based employee benefit consulting and administrative firm that serves private-held companies, publicly traded companies, and public sector employers. He blogs at The Retirement Plan Blog and can be reached at jerry@nationalbenefit.com.

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June 2, 2009 8:59 AM