As a retirement plan provider, we set up many 401(k) plans for many of our clients. But one question often comes up. Can you include life insurance in a 401(k) plan?
Life insurance in a qualified retirement plan can be an excellent option for many high-income taxpayers. But it only works well in certain situations.
In this post, we will talk about how to combine life insurance and 401(k) plans. I will discuss all the IRS rules and make sure you understand the pros and cons. Let’s get started.
Some background
Life insurance can be purchased as part of a qualified retirement plan, such as a 401(k) or a defined benefit plan, but specific rules and limitations apply. Here are some of the critical rules for purchasing life insurance in a qualified retirement plan:
- Plan sponsor discretion: The decision to offer life insurance in a qualified retirement plan is up to the sponsor, typically the employer. The plan sponsor must decide whether to offer life insurance as an option in the plan and what type of life insurance to offer.
- Limits on premiums: The premiums paid for life insurance coverage within a qualified retirement plan must be considered “reasonable and necessary” by the IRS. This means that the premiums paid cannot be excessive compared to the benefits provided. The plan sponsor must ensure that the premiums paid for life insurance do not cause the plan to fail the nondiscrimination tests required by the IRS.
- Limits on death benefits: The death benefits provided by life insurance coverage in a qualified retirement plan cannot exceed the lesser of the employee’s actual death benefit or $5 million.
- Tax implications: The premiums paid for life insurance coverage in a qualified retirement plan are considered a plan expense and are tax-deductible. However, the death benefits received by the employee’s beneficiary are typically subject to income tax, unlike other types of retirement plan benefits, which may be tax-free.
- ERISA requirements: The Employee Retirement Income Security Act (ERISA) requires that the fiduciaries of a qualified retirement plan act in the best interests of the plan participants and beneficiaries. This includes ensuring that the plan’s life insurance coverage is appropriate and cost-effective.
The “Incidental Benefit” Limitation
There are few limitations within the Internal Revenue Code on the types of assets that may be purchased by qualified plans to fund participant benefits. The plan trustee can use the contributions to purchase any investments permitted by the plan to the extent they are not restricted by law.
However, there are limitations on the types of benefits that may be included in a qualified retirement plan. The benefit limitation restricts the amount of life insurance that can be held within the plan.
Qualified profit-sharing plans are supposed to be a source of retirement benefits mainly. As such, any benefit provided by a qualified 401k plan, which is not a retirement benefit, should be limited in scope. In other words, such benefits should be “incidental” to the goal of providing retirement income.
| Inside Plan | Outside Plan |
|---|---|
| Tax Deductible Premiums | After-Tax Premiums |
| Incidental Benefit Limit | No limit on Premiums |
| 1099 for Economic Benefit | Tax-Free Death Benefit |
| Must be Split Funded | Cash Surrender Value |
A pension retirement plan can provide for the payment of a pension due to disability and can also provide for the payment of incidental death benefits through insurance.
This restriction is commonly referred to as the “incidental benefits” rule. The various standards the IRS has developed to measure such benefits may be called incidental benefits tests.
Determining whether a particular level of death benefits is incidental and selecting which incidental benefits test to apply will depend upon the plan type. Qualified plans are classified as defined contribution plans or defined benefit plans based on whether the plan specifies a company contribution rate or if the plan guarantees a certain benefit level. The IRS has adopted standards for applying the incidental benefits rule to these two different plan types.
What is a 401k plan?
A 401(k) plan is an company-sponsored retirement savings plan that allows employees to save and invest a portion of their salary on a tax-deferred basis. 401(k) plans are named after the U.S. tax code section governing them.
Under a 401(k) plan, employees can contribute a percentage of their pre-tax salary into the plan up to an annual limit set by the IRS. The contributions are invested in a range of investment options, such as mutual funds, CDs, stocks, and bonds, chosen by the employee from options offered by the plan. The earnings on the investments grow tax-free until they are withdrawn.
In addition to employee contributions, many employers also offer matching plan contributions up to a certain percent of the employee’s salary, which can help employees save even more for retirement. One key benefit of a 401(k) plan is that the contributions are made pre-tax, which can lower an employee’s taxable income and reduce their tax bill. However, when funds are withdrawn from the plan during retirement, they are subject to income tax.
Another benefit of a 401(k) plan is that the contributions are portable, meaning employees can take their vested account balance with them if they change jobs. However, funds withdrawn before age 59 1/2 may be subject to a 10% penalty in addition to income tax.
