The purpose of a qualified retirement plan is to provide participants with retirement income. If the IRS determines that the primary purpose of a qualified plan is not for retirement benefits, the plan will be disqualified and lose its tax advantage.
The purchase of life insurance must be secondary or “incidental” to the retirement goals of the plan. Qualified plans “may provide for the payment of incidental death benefits through insurance or otherwise.” See Reg 1.401-1(b)(1)(i). These rules are called the “incidental death benefit rules.” An employer can take a tax deduction for contributions to a retirement plan to the extent it provides only an incidental death benefit.
Background
Restrictions on the purchase of life insurance are not found in the Internal Revenue Code or regulations. Instead, guidelines have been developed through a series of revenue rulings. Different guidelines exist for the type of insurance being purchased (term, whole life, universal life) and the type of qualified plan (defined benefit, defined contribution, profit-sharing).
For universal life, indexed universal life, variable universal life or term insurance, the rule is modified. Death benefits will be deemed incidental if less than 25% of the total funds allocated to a participant’s account are used to purchase life insurance.
For whole life, less than 50% of the aggregate employer contributions allocated to a plan participant’s account can be applied to the purchase of life insurance.
An additional guideline can be optionally used in defined benefit plans. This test provides that life insurance is incidental if the participant’s insured death benefit is no more than 100 times the expected monthly benefit payable if the insured retires at normal retirement age (Rev. Rul. 74-307, 1974-2, CB 126, Rev. Rul. 76-353-1976-2).
Although either test — the percentage of contributions test or the “100 times rule” — can be used with defined benefit plans, many plan designers suggest reliance on the percentage test. In many cases, the amount of insurance that can be purchased will be larger using the percentage test.
In addition, when the percentage test is used, at the death of an active plan participant, both the insurance benefit and the accrued vested plan benefit would be available for payout as a plan death benefit. However, if the “100 times rule” is used, the accumulation funds remain within the plan, and only the life insurance death benefit would be paid out to the participant’s plan beneficiary.
Step #1 – Obtain Client Information
Here is the information needed from the client:
- Client name
- Client birthdate
- Desired contribution
- Entity structure
Q&A
Does the insurance need to be set up upfront or can it be done later?
What is the maximum death benefit under the 100 times rule?
Definitions:
Term Insurance
Term life insurance, also known as pure life insurance, is a type of death benefit that pays the heirs of the policyholder throughout a specified period of time.
Once the term expires, the policyholder can either renew it for another term, convert the policy to permanent coverage, or allow the term life insurance policy to lapse.
When you buy a term life insurance policy, the insurance company determines the premium based on the policy’s value (the payout amount) and your age, gender, and health.
Term life policies have no value other than the guaranteed death benefit. There is no savings component as is found in a whole life insurance product.
Whole Life Insurance
Whole life insurance, also known as traditional life insurance, provides permanent death benefit coverage for the life of the insured. In addition to paying a death benefit, whole life insurance also contains a savings component in which cash value may accumulate. Interest accrues at a fixed rate and on a tax-deferred basis.
Whole life insurance policies are one type of permanent life insurance. Universal life, indexed universal life, and variable universal life are others. Whole life insurance is the original life insurance policy, but whole life does not equal permanent life insurance as there are many types of permanent life.
Whole life insurance guarantees payment of a death benefit to beneficiaries in exchange for level, regularly-due premium payments. The policy includes a savings portion, called the “cash value,” alongside the death benefit. In the savings component, interest may accumulate on a tax-deferred basis. Growing cash value is an essential component of whole life insurance.
Universal Life Insurance
Universal life (UL) insurance is a type of permanent life insurance that, like other permanent insurance, has a cash value element and offers lifetime coverage as long as you pay your premiums. Unlike whole life insurance, universal life allows you to raise or lower your premiums within certain limits, and it can be cheaper than whole life coverage. However, if your investments underperform or you underpay for too long, it could affect your death benefit or cause your policy to lapse.1
UL insurance provides more flexibility than whole life insurance. Policyholders can adjust their premiums and death benefits. UL insurance premiums consist of two components: a cost of insurance (COI) amount and a saving component, known as the cash value.