We are huge fans of cash balance pension plans. When our clients are looking for large tax deferrals, these are the first plans we go to.
But there are other retirement structures that can make a lot of financial sense. A profit-sharing plan is one such structure that can be combined with a defined benefit plan to maximize annual contributions.
One twist on a profit-sharing structure is including life insurance in the plan. It allows for a tax deduction relating to the annual premium payments. In addition, there are seasoned funds that can be used for life insurance when individual cash flow might be tight.
In this post, we will discuss how life insurance can be included in profit-sharing plans. I will walk through a few scenarios and show you when this strategy can be a home run. Let’s get started.
Incidental Benefit Rules
The IRS adopted qualified plan rules decades ago. These plans are established to provide retirement benefits for employees. The most popular qualified plan is the 401(k).
Even though the primary purpose of these plans is for retirement, the IRS allows a specific portion of total contributions to be allocated to life insurance benefits. However, the IRS has established strict rules to ensure that the life insurance benefits provided are incidental to the retirement benefits. Said differently, the primary purpose of this plan is to provide retirement benefits with a small incidental amount being contributed to life insurance.
The IRS does not expressly limit the types of investments that can be acquired within a retirement plan. Life insurance is not disallowed.
| Inside Plan | Outside Plan |
|---|---|
| Tax Deductible Insurance Premiums | After-Tax Insurance Premiums |
| Incidental Benefit Limitations | No Premium Limit |
| Taxable Economic Benefit | Tax-Free Death Benefit to Beneficiary |
| Split Funded Requirement | Cash Surrender Value |
But over the last several decades, the IRS has released revenue rulings to support specific court cases. These guidelines aim to clarify how insurance can be used within a pension retirement plan. Furthermore, there are two types of retirement plans: define contribution plans and find benefit plans. The IRS has established separate but comparable rules for each plan type.
These IRS rules and clarifications are often called the incidental benefits rules. There are tests that are applied to these rules to determine whether they meet the IRS guidelines.
A profit-sharing plan is often attached to a 401(k). It is considered a defined contribution plan. The reason is because annual limitations are imposed, and once an employee contributes to the plan, they can take that deduction in the current year. Unlike a defined benefit plan, profit-sharing plan asset balances are irrelevant to compliance. As such, it does not matter whether the assets go up or down. Deduction limits are adjusted annually.
Since profit-sharing plans don’t allow for a specific retirement benefit, examining the percentage of plan contributions is the primary test used to determine life insurance compliance.
Can a Profit-Sharing Plan Hold Life insurance?
For profit-sharing plans, the rules for purchasing life insurance are as follows:
If the plan document makes use of the seasoned money exception:
- Where the funds used to purchase life insurance have been in the plan for two or more years, there is no limit to how much life insurance can be purchased within the plan;
- Where the plan participant has participated in the plan for five or more years, there is no limit to how much life insurance can be purchased within the plan.
If the plan document allows current contributions to be applied towards the purchase of life insurance:
- Where the death benefits are funded with whole life insurance, the premiums paid are less than 50% of the contributions to the plan for each participant;
- Where the death benefits are funded using other types of life insurance (such as term insurance or universal life insurance), the premiums paid are less than 25% of the contributions to the plan for each participant;
- When the death benefit is funded with both whole life insurance and other insurance types, the sum of one-half of all premiums paid for whole life plus the premiums paid for any other types of life insurance is less than 25% of the plan contributions for each participant; and
- The plan document must require the plan trustee converts the full value of all life insurance contracts into specific cash or periodic income at or before each employee’s retirement and/or to dispose or distribute each life insurance contract over to the insured employee at or before entering retirement.
“Seasoned Money” in Profit-Sharing Plans
There is an exception to the percentage limitations test for funds accumulated within a profit-sharing plan for the period required by the plan document for deferred distributions. These funds are often referred to as “seasoned money.”
Where a profit-sharing plan restricts the purchase of life insurance to funds that have been accumulated for a ”fixed number of years” (i.e., where only seasoned money can be used to pay life insurance premiums), there is no limit to the amount of life insurance that can be purchased within the plan. This is the “seasoned money” exception.
Funds accumulating in a profit-sharing plan can be segregated into current funds and seasoned money. If a plan allows current funds to be applied towards life insurance, the purchase must comply with the incidental benefit rule and the percentage limitations test.
If only seasoned money is permitted to purchase life insurance, no incidental benefit limitation exists. All seasoned money may be used to buy life insurance in a profit-sharing plan.
The ‘Swap Out’ or ‘Buy Out’
A participant who holds life insurance within a defined contribution plan cannot roll over the insurance policy itself. However, they can exchange the policy for an equivalent amount of cash and then roll over that cash instead.
Participants may execute non-reportable “swap-outs.” In this process, the participant pays the plan the policy’s cash value in exchange for receiving the insurance policy directly. This enables the participant to distribute the full value of their plan investment balance (including the policy’s cash value), complete the rollover, and retain the policy outside the retirement plan.
For example, suppose Phil has a life insurance policy in his profit-sharing plan with a death benefit of $200,000 and a cash value of $30,000. To swap out the policy, Phil provides $30,000 of his own funds to the plan administrator.
In return, the plan administrator reregisters the insurance policy in Phil’s name (removing it from the plan) and distributes the contract to him. As a result, no taxable event occurs, and Phil can take a distribution and roll over the entire amount to his IRA.
Is a Cash Balance or Defined Benefit Plan Right For You?
IRS Requirements
To keep the death benefit “incidental,” the IRS has laid out safe-harbor style limits in published guidance. For example, IRS guidance has treated ordinary (cash value) life insurance as incidental in a profit-sharing trust when, for each participant, aggregate premiums stay under one-half of aggregate contributions allocated to the account, and the plan requires the policy value be converted/distributed by retirement.
IRS training materials also describe a “general 25 percent incidental benefit rule” (commonly applied to term/universal-type coverage) and emphasize that plan value generally can’t be used to continue life insurance protection beyond retirement.
Finally, the IRS expects the current life insurance protection provided inside the plan to be valued and reported as an economic benefit. The IRS has published Table 2001 as an accepted method to value that current protection, including for coverage provided under a qualified retirement plan.
Separately, IRS guidance has also explained that using qualified plan trust funds to pay the cost of life insurance for an employee is treated as a distribution within IRC §402’s framework—one reason the annual “cost of insurance protection” reporting matters.
The main IRS guidance relating to life insurance in profit-sharing plans is:
What happens when life insurance is part of a qualified plan?
Seasoned money is money that has been in a profit-sharing plan for a “fixed number of years.” According to the IRS, a fixed number of years must be at least two years.
Alternatively, all contributions to a profit-sharing plan may be considered seasoned money (even contributions that are less than two years old) if the participant has been in the plan for at least five years and the plan document permits deferred distribution of all contributions at that time.
Yes, it is. Profit-sharing plans, including 401(k)s, are among the most popular plan types. They technically fall under the defined contribution plan rules. This contrasts to defined benefit plans and cash balance plans that have separate insurance rules under IRS requirements.
You can, but only if it is a 401(k) plan. Most 401(k) plans have two components, an employee deferral, and an employer profit-sharing. Most profit-sharing plans are technically 401(k)s that allow profit-sharing. Please check with your administrator and find out what type of plan you have. In most situations, you want the flexibility of making both employer and employee contributions.
Most profit-sharing plans are 401(k)s. They allow the employees to contribute based on employee wages or business profits for a solo plan. Profit sharing contributions will generally be based on percentages depending on the business entity structure. A profit-sharing plan can also be combined with defined benefit plans to make higher overall contributions.
What is a qualified retirement plan?
A qualified plan is a company-sponsored retirement plan that meets specific requirements under the Internal Revenue Code (IRC) to receive favorable tax treatment. These plans encourage individuals to save for retirement by allowing them to defer taxes on the money they contribute to the plan until they withdraw the funds during retirement.
Qualified retirement plans include 401(k) plans, profit-sharing plans, and defined benefit pension plans. These plans must meet certain requirements set forth by the IRC, such as nondiscrimination testing, contribution limits, and vesting rules.
Qualified retirement plans offer many benefits to employers and employees, including tax savings, potential investment growth, and attracting and retaining employees. However, these plans also come with certain obligations and responsibilities for employers, such as plan administration and compliance with regulatory requirements.
Bottom Line
Including life insurance inside a profit-sharing plan can be powerful, but only when it stays clearly “incidental” to retirement benefits. Done correctly, it can pair a retirement funding strategy with meaningful protection planning. The best outcomes usually come from designing the plan up front with the end game in mind.
If premiums are paid from current-year contributions, the plan generally has to stay within the incidental benefit percentage limits. As a rule of thumb, whole life premiums typically must remain under 50% of that participant’s contributions, while other coverage types are commonly limited to 25%, with a blended test when both are used. If the plan uses “seasoned money,” those percentage limits may be avoided when funds meet the required seasoning rules (often two years in-plan, or five years of participation if the plan document allows it).
The execution details matter as much as the concept. The plan document must permit the arrangement, and the trustee has to follow the required retirement-time handling of the policy (conversion, disposal, or distribution). And don’t forget the “economic benefit” reporting while coverage is inside the plan, plus the practical decisions around distributing the policy and determining fair market value.
