A defined benefit plan offers small business owners a powerful retirement structure. Investors typically allocate assets to stocks, bonds, or mutual funds. However, a split-funded defined benefit plan takes a unique approach.
In a split-funded strategy, investors fund the plan with two asset classes. They direct half of the contributions to traditional investments and use the other half to purchase life insurance. This dual funding method generates both retirement income and survivor protection.
In this post, we discuss several strategies commonly used with split-funded plans and share a few tips and tricks. Let’s jump in!
The Role of Life Insurance in Funding
Life insurance plays an important role in a split funded plan. Policies are purchased within the retirement plan and funded using contributions. Premiums are paid with pre-tax dollars, creating tax-advantaged funding.
The insurance provides a death benefit to protect beneficiaries if the participant dies early. The policy’s cash value also grows on a tax-deferred basis. This value can supplement retirement benefits over time. Life insurance strengthens retirement security while covering unforeseen risks.
A split funded plan uses a 50/50 allocation method. Half of the funding goes to insurance. The other half supports traditional investments like equities or bonds. This balance creates long-term retirement growth with financial protection.
The investment portion seeks returns to grow plan assets. The insurance portion ensures family protection and a guaranteed payout. Together, they provide a more comprehensive solution. This diversification supports both accumulation and protection goals.
Balancing Investments and Insurance
The IRS allows life insurance to be included in a defined benefit plan only if it meets the incidental benefit requirement. This rule ensures that retirement savings remain the plan’s primary purpose, while life insurance coverage stays secondary.
The requirement limits the amount of insurance purchased relative to plan contributions and benefits. Typically, whole life policies are limited to 50% of contributions, while term or universal policies are limited to 25%.
These restrictions prevent excessive use of tax-deductible plan contributions to fund large insurance policies. By keeping life insurance benefits “incidental,” the plan maintains compliance with tax-qualified status.
Employers and advisors must monitor policy allocations to ensure they remain within IRS guidelines. Failure to comply can result in disqualification of the plan and significant tax consequences for participants.
Tax Advantages of Split Funding
Split funded defined benefit plans provide strong tax advantages. Contributions are generally tax-deductible for employers. Employees do not pay tax on employer contributions until benefits are received.
Life insurance premiums are tax-deductible under certain incidental benefit rules. The plan assets grow on a tax-deferred basis. This allows investments and insurance values to compound over time. Ultimately, participants benefit from reduced current tax liabilities and enhanced retirement savings.
Compliance and IRS Guidelines
The IRS enforces specific rules for life insurance in retirement plans. Policies must meet incidental benefit tests to qualify. Typically, this means insurance cannot dominate plan assets. The 50/50 split structure helps maintain compliance.
Actuaries and advisors monitor contributions and policy values. Regular plan reviews are required to maintain IRS approval. Noncompliance can result in disqualification and tax penalties. Employers must work with experts to ensure the plan is properly structured.
Benefits and Potential Drawbacks
Split funded defined benefit plans offer unique advantages. Participants enjoy both retirement savings and life insurance coverage. The combination provides family protection and a secure income stream. Tax benefits enhance the overall strategy.
However, there are potential drawbacks to consider. Life insurance policies can be costly compared to traditional investments. Administrative oversight is more complex. Employers must manage contributions carefully to stay compliant. While powerful, this plan type is not suitable for all businesses.
| Section | Core Idea | Notable Details |
|---|---|---|
| Overview | Split-funded DB plans combine investments and life insurance. | Typically allocate 50% to traditional assets and 50% to life insurance for growth plus protection. |
| Life Insurance’s Role | Policies are held inside the plan to add survivor benefits. | Premiums can be paid with pre-tax dollars; cash value grows tax-deferred; death benefit protects beneficiaries. |
| Balancing the 50/50 Mix | Half funds insurance; half funds equities/bonds. | Diversification targets long-term asset growth while ensuring guaranteed protection from the policy. |
| Incidental Benefit & Compliance | Insurance must remain “incidental” to retirement benefits. | Typical limits: up to 50% for whole life; 25% for term/universal; ongoing monitoring required to stay compliant. |
| Taxes, Pros & Cons | Employer contributions are generally deductible; assets grow tax-deferred. | Pros: family protection and tax benefits. Cons: higher policy costs and greater administrative complexity. |
Final Thoughts
A split funded defined benefit plan blends retirement savings and life insurance. With 50% allocated to investments and 50% to insurance, the plan balances growth with protection. It offers tax benefits, financial security, and family coverage.
Employers should evaluate funding levels and compliance requirements before adopting this strategy. Professional guidance ensures the plan is structured correctly. When implemented properly, split funding provides a strong and flexible retirement solution.
