Case of the Week: Life Insurance in Qualified Plans

The ERISA consultants at the Retirement Learning Center Resource regularly receive calls from financial advisors on a broad array of technical topics related to IRAs, qualified retirement plans and executive compensation arrangements.

A recent call with an advisor in Colorado is representative of a common inquiry involving life insurance in qualified plans. The advisor asked:

I’ve heard that sponsors of qualified retirement plans can offer life insurance as a type of investment within the plan. If that is true, what are the requirements to do so?”

Highlights of Discussion

While life insurance is prohibited within IRAs, it is true that some qualified plans permit participants to purchase life insurance with a portion of their individual accounts within their workplace retirement plans. [See Treasury Regulation §§1.401-1(b)(1)(i) and (ii).]

If life insurance is offered as an investment within a retirement plan, the following are some critical points to keep in mind.

Death benefits must be “incidental,” meaning they must be secondary to other plan benefits. For defined contribution plans, life insurance coverage is considered incidental if the amount of employer contributions and forfeitures used to purchase whole or term life insurance benefits under a plan are limited to 50% for whole life and 25% for term policies. No percentage limit applies if the participant purchases life insurance with company contributions held in a profit sharing plan for two years or longer. [See IRS Revenue Ruling 54-51 and PLR 201043048.

For a defined benefit plan, life insurance coverage is generally considered incidental if the amount of the insurance does not exceed 100 times the participant’s projected monthly benefit.

If the plan uses deductible employer contributions to pay the insurance premiums, the participant will be taxed on the current insurance benefit. This taxable portion is referred to as the P.S. 58 cost. Insurance premiums paid by self-employed individuals are not deductible.

A participant with a life insurance policy within a retirement plan generally may not roll over the policy (but he or she may swap out the policy for an equivalent amount of cash, and roll over the cash).

Participants may exercise nonreportable “swap outs.” In a life insurance swap out, the participant pays the plan an amount equal to the cash value of the policy in exchange for the policy itself. This transaction allows the participant to distribute the full value of his or her plan balance (including the cash value of the policy), and complete a rollover, while allowing the participant to retain the life insurance policy outside of the plan.

Swap Out Example

Anne has a life insurance contract in her 401(k) plan with a face value of $150,000, and a cash value of $25,000. She elects to swap out the policy and gives the administrator a check for $25,000. In return, the administrator reregisters the insurance policy in Anne’s name (rather than in the plan’s name), and distributes the contract to her. There is no taxable event and Anne may take a distribution (once she has a triggering event) and roll over the entire amount received.

Conclusion

It is possible that a qualified retirement plan may allow participants to invest in life insurance under the plan. Check the terms of the document to determine whether it is an option and follow the incidental benefit rules.

APEX 2017_winner 125x130 “Case of the Week” is the winner of an APEX Award for Publication Excellence for 2017.

Any information provided is for informational purposes only. It cannot be used for the purposes of avoiding penalties and taxes. Consumers should consult with their tax advisor or attorney regarding their specific situation.

©2017, Retirement Learning Center, LLC. Used with permission.

Add Your Comments

One Comment

  1. Ernie Guerriero
    Posted December 6, 2017 at 10:33 am | Permalink

    The “swap out” example is not correct regarding the taxation. When a qualified plan distributes the life insurance contract the “fair market value” of the contract is the purchase price to avoid taxation (minus any applicable economic benefit costs, and not necessarily the “cash value”, refer to Treas. Reg. §1.402(a)-1(a)(1)(iii); Notice 89-24, Q&A 10; and Rev. Proc. 2005-25.

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