High-net-worth individuals often seek tax-efficient strategies to transfer wealth. One often overlooked option is including life insurance within a defined benefit (DB) retirement plan.
While defined benefit plans are known for maximizing retirement income, they can also provide meaningful estate tax benefits—especially when paired with a carefully structured life insurance policy. But there are some special rules that need to be considered.
In this post, we discuss how this unique structure works and detail out all the estate tax benefits. Let’s jump in!
How It Works
In a defined benefit plan, employers promise a fixed payout at retirement, typically based on salary and years of service. These plans are subject to strict IRS funding requirements. However, within those limits, employers may include life insurance policies as part of plan funding, as long as the insurance remains an incidental benefit.
Typically, the plan purchases a whole life or universal life policy on the participant’s life. Premiums are paid with tax-deductible employer contributions, and the policy may accumulate cash value while also providing a death benefit.
When a defined benefit plan purchases life insurance on a participant’s life, the premiums are funded with employer contributions. These contributions are tax-deductible to the business and do not count as gifts from the participant, which means the premiums are not added to the participant’s taxable estate. This setup effectively shifts the cost of insurance out of the estate and into the retirement plan structure.
Estate Tax Benefits
1. Removes Insurance Premiums from the Taxable Estate
Because life insurance is paid for using employer contributions into the defined benefit plan, the participant is not personally funding the policy. This keeps premium payments out of the individual’s taxable estate, reducing exposure to estate taxes.
However, this strategy comes with important compliance requirements. The life insurance policy must remain incidental to the retirement plan’s primary purpose. Under IRS rules, no more than 50% of contributions can be used for whole life insurance premiums.
Additionally, the policy’s death benefit must not exceed 100 times the participant’s projected monthly retirement benefit. These limitations ensure that the retirement plan does not become a disguised life insurance vehicle.
2. Provides Liquidity for Estate Taxes
The death benefit from the life insurance can be used to pay estate taxes, preserving other estate assets like business interests or real estate. Without insurance, heirs may be forced to liquidate illiquid assets at a discount.
The life insurance death benefit can also provide critical liquidity to the estate. Upon the participant’s death, the payout from the policy can be used to cover estate taxes or settle debts, preventing the need to sell illiquid assets like a business or real estate holdings.
In some cases, if the policy is transferred to the participant before death—either through a buyout or distribution—it may reduce the taxable value of the retirement plan included in the estate. If structured carefully, this can lower the overall estate tax burden.
3. Reduces Value of Retirement Plan at Death
If the policy is structured to be distributed to the participant before death (for example, via a buyout or policy transfer), it may reduce the taxable value of the retirement plan included in the estate. This can lead to a lower estate tax valuation if done correctly.
Another key consideration is avoiding the “transfer for value” rule when distributing the policy. If the policy is transferred for something of value to a non-exempt party, it can jeopardize the tax-free nature of the death benefit. Proper legal and tax structuring is essential to ensure the benefits are preserved.
4. Supports Advanced Estate Planning with ILITs
A defined benefit plan can be designed to distribute a policy to an Irrevocable Life Insurance Trust (ILIT). When properly executed, this removes the policy’s death benefit from the participant’s gross estate entirely. The trust becomes the owner and beneficiary of the policy, and the death benefit passes outside the estate, avoiding estate taxation altogether.
An even more effective strategy is to distribute the policy from the defined benefit plan into an irrevocable life insurance trust (ILIT). Once inside the trust, the policy is no longer owned by the participant, and the death benefit passes outside the estate entirely.
This removes the entire insurance value from the taxable estate, further reducing exposure to estate taxes. The ILIT can also control how the insurance proceeds are distributed to heirs, offering protection and long-term planning advantages.
Final Thoughts
Including life insurance in a defined benefit plan can be a powerful estate tax strategy for high-income individuals. Defined benefit plans are primarily designed to provide retirement income, but they can also serve estate planning goals when structured properly. By incorporating a life insurance policy within the plan, participants may gain significant tax advantages that reduce the taxable value of their estate and ensure smoother wealth transfer.
This strategy is particularly effective for business owners, high-earning professionals, and individuals with large estates who need liquidity at death. By combining retirement planning with estate tax reduction, it provides a highly efficient way to protect wealth. With the help of skilled advisors, including life insurance in a defined benefit plan can create a tax-advantaged legacy that benefits both the participant and their heirs.
