Including life insurance in a profit-sharing plan can enhance both retirement planning and family protection. Yet, it involves navigating IRS rules, contribution limits, and compliance tests.
These arrangements are inherently complex and require careful administration to remain tax-qualified. Without clear guidance, employers and participants may struggle to understand how the strategy works or where pitfalls reside.
This how-to guide walks you through each critical step of integrating life insurance into a profit-sharing plan. It covers plan design considerations, funding strategies, incidental benefit requirements, and record-keeping essentials. Let’s get started!
Determine if the plan allows life insurance
The first step is to determine whether or not life insurance is actually allowed to be included in the plan. If your 401(k) is from a custom document provider, it is likely allowed. However, if you are using a cookie-cutter plan from Schwab, Fidelity, or Vanguard, then that is likely not the case.
You would have to amend your existing plan. Assuming your current custodian accepts the amended plan, you can leave your assets with your existing custodian. You will need to distribute funds from the custodian account to fund the insurance.
Determine how much of your profit sharing is allowed for life insurance
You’ll want to review the incidental benefit rules and the seasoned money rules to determine how much of your profit sharing qualifies for insurance. In our experience, most clients will easily meet the seasoned money rule. However, you’ll need to analyze to determine this.
Break out the profit-sharing in your 401(k) plan from your employee deferrals
Remember that a typical 401(k) plan includes components for both employee deferrals and employer profit-sharing. Employee deferrals cannot be used to fund life insurance. These are salary deferrals and not employer contributions. These funds are not allowed to be used for life insurance.
You must review the account to determine the profit-sharing portion of the 401(k) account. You’ll also need to calculate a weighted average of the contributions, as interest and dividends should be allocated appropriately between the deferral and profit-sharing portions for each year.
This exercise sounds very challenging, and in some situations it is. However, if you have a 401(k) plan that you’ve had for a long time and has a large amount in it, such as $500,000 or more, you might find that it would be very easy to determine that you have at least enough profit-sharing funds to allocate to the life insurance. So in practice, this might not be too difficult.
Determine your life insurance needs
Once you’ve established the amount of profit-sharing funds you have, it’s time to determine your life insurance needs. You’ll need to ask yourself the following questions:
- Do I want to make a lump sum payment upfront or spread it over a longer period of time?
- How much of a death benefit do I want?
- Are there any specific writers or extras that I would like to add to the plan?
Once you have answers to the above questions, you can determine the type of policy you’ll include in the plan.
Understand your taxable income resulting from the PS 58 costs
PS-58 costs represent the imputed economic benefit of pure life insurance protection inside a qualified plan, such as a profit-sharing plan. When life insurance is held within a plan, the IRS requires that the cost of current protection be treated as taxable income to the participant. These costs are calculated annually, typically using either the IRS’s Table 2001 rates or approved carrier term rates.
While the taxable income resulting from the PS 58 cost is not significant, you want to make sure you understand it upfront. You also want to keep in mind that you will receive a 1099–R at the end of the year. The good news is that this 1099-R will not result in a 10% penalty; however, it will be subject to income tax.
If this discussion is not had upfront, it often comes as a surprise to the client and can result in a disgruntled client. Just make sure everybody understands has a rough idea of the amount upfront, so it is not a surprise.
Although PS-58 costs create a small annual tax burden, they are outweighed by the tax advantages of including life insurance in a profit-sharing plan. Employers still deduct contributions used to fund premiums, while participants enjoy long-term retirement savings and survivor protection.
Take any required medical exams
The next step is to schedule your life insurance exam. For some policies, no examination is required. For others, the examination typically consists of a series of questions and a blood test.
Getting a medical exam is a common part of applying for life insurance. Insurers use the exam to evaluate your overall health. The results help determine risk levels, premium rates, and eligibility for coverage. Typically, the exam includes height, weight, blood pressure, blood tests, and sometimes urine samples. These details give insurers a snapshot of your health profile.
The exam is usually scheduled at your convenience. A paramedical professional may come to your home, office, or a clinic. The process is quick, often taking less than an hour. To prepare, you may be asked to fast, avoid caffeine, and limit exercise before the appointment. Following instructions ensures accurate results and avoids delays in underwriting.
Insurers rely heavily on the exam to set policy terms. Favorable results can qualify you for lower premiums and preferred rates. Conversely, health concerns might increase costs or limit available coverage.
While some policies allow no-exam options, these often carry higher premiums. Completing a medical exam is usually the best way to secure affordable and comprehensive life insurance.
If you smoke or have other health issues, it can be challenging to obtain life insurance. Each situation is different.
Basic example
Let’s look at an example. Assume someone has a profit-sharing plan with $150,000 balance. Let’s also assume that $90,000 of this is employee deferral and $60,000 is employer profit-sharing. With the profit-sharing amount only, you would technically structure the life insurance component as follows:
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- Transfer the $60,000 to an insurance company, which will then put the money into a “suspense” account.
- For each of the next 5 years, the suspense account will be debited for $12,000 to fund the life insurance policy.
- The money that is retained in the suspense account will receive a guaranteed return that is generally 4% to 5%.
At the end of 5 years, you have fully funded life insurance policy with tax-deductible funds.
Final thoughts
Life insurance in a profit-sharing plan can deliver meaningful advantages, but only when structured and administered correctly. It combines the tax benefits of qualified plan contributions with the peace of mind of permanent protection. For many business owners and professionals, this strategy offers a unique balance of retirement growth and family security.
The key to success lies in following IRS guidelines carefully. Employers must respect percentage limits, apply seasoned money rules, and report PS-58 costs consistently. With proper oversight, these requirements become manageable. Compliance not only safeguards the plan’s qualified status but also ensures that the tax advantages are fully preserved.
Ultimately, profit-sharing plans with life insurance should be viewed as a long-term strategy. When paired with sound estate planning, the approach maximizes deductions, protects families, and strengthens retirement outcomes. With the right design and professional guidance, employers and participants can unlock powerful financial benefits that extend well beyond retirement.
