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?
401k life insurance plans are possible. They can be an excellent option for many high-income taxpayers. But they only works well in certain situations.
In this post, I will talk about 401k life insurance. 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 401k life insurance plans:
- 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.
401(k) Life Insurance Rules
Life insurance can be incorporated into a 401(k) profit sharing plan, but specific rules and limitations must be carefully followed to maintain the plan’s tax-qualified status. The Internal Revenue Service permits life insurance as an investment option within profit sharing plans under Section 401(a) of the Internal Revenue Code, provided that the life insurance is “incidental” to the plan’s main retirement objective. This means that the life insurance protection cannot be the predominant benefit offered to participants.
Participants in profit sharing plans with life insurance face unique tax implications that differ from traditional retirement plan contributions. While contributions to the retirement portion of the plan remain tax-deferred, participants must pay current income tax on the cost of life insurance protection, known as “Table I costs” or “PS 58 costs.”
This taxable amount represents the value of the current life insurance protection and must be reported as income each year the coverage is in effect. The participant’s basis in the contract increases by these taxable amounts, which can provide tax advantages when benefits are eventually distributed.
Distribution rules for 401k life insurance in profit sharing plans require careful planning to optimize tax outcomes and comply with regulatory requirements. When a participant separates from service, they may receive the life insurance policy as a distribution, convert it to an individual policy, or have the plan surrender the policy and distribute the cash value. If the participant receives the policy directly, they are taxed only on the policy’s cash value minus their basis (the cumulative PS 58 costs previously taxed).
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. 401(k) life insurance 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 401(k) 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) life insurance 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.
Final Thoughts
While setting up a 401k life insurance plan is possible, it’s a strategy that must be approached with precision, and expert guidance. The IRS allows for limited inclusion of life insurance—primarily for incidental death benefit protection—not as a core retirement investment. Understanding the rules, contribution limits, and compliance requirements is essential to avoid plan disqualification and unintended tax consequences.
For high-income individuals or business owners, integrating life insurance into a retirement plan may offer strategic advantages—such as tax-deferred growth, enhanced protection, and estate planning benefits—but it must be structured properly. Working with an experienced plan administrator ensures that your 401(k) remains compliant while helping you meet both your retirement and insurance goals.
At Emparion, we specialize in advanced retirement planning strategies and can help you evaluate whether this option fits your broader financial picture.
