You have probably heard of a defined benefit plan. But do you know that you can put life insurance in a defined benefit plan?
Business owners obtain tax-deductible life insurance that provides a tax-free death benefit. It can literally be a win-win solution.
In this post, we examine this little-known retirement strategy. Let’s jump in!
Some Background
Life insurance in a defined benefit (DB) plan combines retirement savings with death benefit protection. A DB plan promises a set benefit at retirement, based on formulas that consider age, salary, and years of service.
By adding life insurance to a pension, the plan can provide both retirement income for the participant and financial security for their family if death occurs before retirement. Premiums for the insurance are paid with tax-deductible employer contributions, allowing the policy to grow inside the plan on a tax-deferred basis.
The IRS permits life insurance in DB plans only if it meets the “incidental benefit rule.” This means the primary purpose of the plan must remain retirement benefits, with life insurance as a secondary feature.
Generally, no more than 50% of employer contributions for whole life insurance (or 25% for term/universal) may be allocated toward premiums. If structured properly, the participant receives both retirement income and a supplemental death benefit, all funded with pre-tax dollars.
At retirement or plan termination, the life insurance policy is usually distributed to the participant. The fair market value of the policy at that time becomes taxable income.
However, the participant then owns the policy personally and can continue coverage or use its cash value. For many high-income professionals, including dentists and business owners, life insurance inside a DB plan provides both a tax-efficient way to secure family protection and an additional layer of retirement planning.
Best Candidates for Life Insurance in a Defined Benefit Plan?
If you fall under the following categories, you should consider taking a life insurance-based defined benefit plan. This is an excellent option for business owners and entrepreneurs who would like:
- the benefits of life insurance but are also in search of a significant tax deduction.
- to maximize the contribution to a retirement plan.
- to get a higher tax deduction when they have higher insurance risks that can offset any increase in premium payments.
- a life insurance policy combined with a retirement strategy and face a limited budget.
- to fund a buy/sell agreement along with a tax deduction. In this situation, the surviving business owner would be the beneficiary of the policy. This provides the cash required to purchase the remaining business interest from the estate of the deceased business owner.
Funding Life Insurance in a Defined Benefit Plan
Under defined benefit plan rules, one can utilize any type of insurance policies without restrictions. Universal or variable life policies can, therefore, be utilized in combination with stocks, mutual funds, bonds, CDs, etc. But an insured 412(e)(3) defined benefit plan is a little different. It is required to utilize a whole life policy in combination with a fixed annuity. Both plans enable business owners to make significant plan contributions. This is a great benefit for owners who are close to retirement age.
However, there are rules that should be followed in order to take advantage of life insurance. First, the “50% test” has to be adhered to. This rule restricts life insurance premiums to no more than 50 percent of total contributions.
The second rule is the “100-to-1” rule. This rule also limits any death benefit to no more than 100 times the related plan participant’s monthly retirement benefit.
What About the Tax Benefits?
Defined benefit plans are well known for their tax benefits, both to employers and employees. Contributions made towards a cash balance plan are deductible for business income, resulting in less tax payable in a given tax year.
Employees also enjoy deferred tax on contributions made until retirement age where they can pay less tax on distributions received. Any growth in the account balance grows tax-deferred, so no annual taxes are paid on the growth of the funds.
Any insurance premiums are of course paid with funds from the plan, meaning that they are tax deductible to the company. Plan participant should, however, be concerned of the additional tax liabilities associated with life insurance based on the cost of the economic benefit. The economic benefit is calculated by an actuary or an insurance company using an IRS Table 2001.
Should a plan participant pass away prior to retirement, a portion of the proceeds would typically be taxed and any death benefit is generally included in the decedent’s estate. Any tax liability would result from the cash value of the policy at the date of death.
Any tax-free proceeds are based on the “net amount at risk”. This would be determined based on the difference between the death benefit and any cash value.
When a participant retires, he has an option to surrender the insurance policy and have all cash proceeds rolled over to an IRA. He can also opt to proceed with the insurance by purchasing the policy from the plan. The policy purchase price is the cash surrender value.
A policy acquired has the same rules and tax treatment as any policy that was purchased with non-qualified funds. The best way to acquire a policy is to have an irrevocable life insurance trust purchase it. This generally prevents the inclusion of any death benefit insurance proceeds in the decedent’s estate.
Life Insurance in a Defined Benefit Plan: Other Considerations?
Before having a life insurance in a defined benefit plan, it is good to consider the following:
- There should be adequate funds available for retirement contributions because the insurance payments rely on them.
- Since the plan is established and maintained for the benefit of participants, the IRS requires that any survivor benefits are incidental to the ultimate retirement benefit. There is a cap placed on the total life insurance that can be included inside the plan itself.
- If any participant dies prior to retirement, the policy would typically be included in the participant’s estate. This could, however, result in federal (and even state) estate tax that may have been avoided.
- Remember that an IRA will be prohibited from owning a life insurance policy. So if a plan is terminated and rolled over, the policy must be purchased, surrendered or distributed to the employee.
- When an employee becomes closer to retirement the cash value will be higher. This of course results in a higher amount required to purchase the insurance policy from the plan.
Buying life insurance in a defined benefit plan is an excellent option especially for business owners who wish to maximize contributions and take advantage of tax deductions. A careful design is however required to ensure success.
Is a Cash Balance or Defined Benefit Plan Right For You?
You should have a financial advisor, tax professional, and a TPA who coordinate together and reduce the administrative burden on the business owner.
| Step | What to Do | Key IRS/ERISA Rules | Tax & Cash-Flow Effects | Common Pitfalls |
|---|---|---|---|---|
| 1) Confirm plan allows insurance | Review the plan document and trust. Amend the plan to permit life insurance if needed. | Qualified plans may hold insurance only as an incidental benefit. | No tax impact yet. Legal fees may apply for amendments and SPD updates. | Buying a policy before the plan is amended or trustee is authorized. |
| 2) Define goals & eligibility | Align death benefit, retirement targets, and cash needs. Identify eligible participants to insure. | Coverage must serve the plan’s purpose for participants; follow nondiscrimination and fiduciary prudence. | Clear objectives reduce over-insurance and excess costs inside the plan. | Insuring ineligible persons or setting benefits inconsistent with plan formulas. |
| 3) Actuarial design & “incidental” test | Have the actuary size coverage consistent with the promised DB benefit. | DB “100× test”: Pre-retirement death benefit generally ≤ 100× the projected monthly accrued benefit at normal retirement age. | Keeps insurance secondary to retirement benefit, preserving plan qualification. | Using the 25%/50% premium tests (those are for DC plans) rather than the DB 100× rule. |
| 4) Select policy type | Choose whole life, general account UL, IUL, or VUL based on risk, guarantees, and costs. | Policy must be owned by the plan trust; beneficiary is the plan/trustee, not the participant. | Premiums are paid from deductible employer contributions allocated to insured participants. | Using term only (no cash value) when long-term funding stability is needed. |
| 5) Ownership & beneficiary structure | Title the policy to the plan trust. Name the plan as beneficiary to fund plan obligations. | Trustee controls the policy. Any collateral assignment to the participant is prohibited. | On pre-retirement death, proceeds flow to the plan to pay survivor benefits. | Naming the participant’s family directly, creating disqualifying prohibited transactions. |
| 6) Premium funding | Fund premiums through annual deductible contributions determined by the actuary. | Stay within actuarially required/constrained contribution ranges; respect coverage corridors. | Contributions are deductible to the sponsor; plan pays premiums from pooled assets. | Overfunding beyond actuarial limits or underfunding that jeopardizes benefits. |
| 7) Annual “economic benefit” reporting | Impute term cost of current death benefit to the participant each year. | Report Table 2001 (or carrier term) cost as taxable W-2 income; adds to participant basis. | Small annual taxable amount to the participant; builds basis against future distribution. | Failing to report PS-58/Table 2001 costs; using unsupported term rates. |
| 8) Ongoing compliance checks | Re-test coverage annually; adjust face amounts as benefits accrue. | Maintain DB 100× incidental limit; follow fiduciary standards, Form 5500, and audit rules. | Right-sized insurance reduces drag on funding and audit risk. | Letting face amounts drift above limits after pay increases or benefit accruals. |
| 9) Pre-retirement death handling | Plan receives proceeds, then pays survivor benefits under plan terms. | Death proceeds to the plan are generally tax-free to the plan; distributions are taxable to beneficiaries. | Provides liquidity for survivor annuities or lump sums without selling plan assets. | Assuming the family receives tax-free insurance when the policy is plan-owned. |
| 10) Retirement/termination “exit” options | Distribute the policy to the participant, surrender inside the plan, or exchange after distribution. | Distribution is taxable at policy FMV less participant basis (incl. prior imputed costs). Policy cannot be rolled to an IRA. | After distribution, participant may 1035-exchange to a new policy; death benefit can then be income-tax-free under IRC §101. | Ignoring loans at distribution (may trigger taxable gain); mishandling FMV valuation. |
| 11) Documentation & governance | Maintain minutes, IPS, policy statements, and insurer due diligence in the plan file. | ERISA fiduciary duties: exclusive benefit rule, prudence, and diversification. | Better defense in audits; evidence of prudent selection and monitoring. | “Set and forget” approach with no periodic review of carrier financial strength and costs. |
| 12) When to consider alternatives | Use split-funding (DB + outside personal policy) or a §412(e)(3) fully-insured plan when appropriate. | Choose structures that meet cash flow, guarantee, and compliance needs. | May simplify taxation of death benefits and reduce plan complexity. | Adding insurance inside the plan when goals are better met outside the plan. |
| Notes: The DB incidental death benefit limit is typically the “100× monthly benefit” test. The 25% (term/UL) and 50% (whole life) premium tests apply to defined contribution plans, not DB plans. Annual imputed PS-58/Table 2001 costs are taxable to the participant and increase basis. Policy distributions are taxable at fair market value less basis; policies cannot be rolled to IRAs. | ||||
Final Thoughts
Funding life insurance inside a defined benefit plan can be a highly effective strategy when used correctly. It offers the opportunity to combine retirement savings with valuable death benefit protection—all while leveraging tax-advantaged contributions. For business owners and high-income professionals, this approach can unlock greater flexibility, enhance estate planning, and create long-term financial security.
But the structure must be carefully designed to meet IRS guidelines, comply with incidental benefit rules, and ensure proper tax reporting. When executed properly, life insurance within a defined benefit plan can provide powerful results far beyond what traditional retirement planning allows.
At Emparion, we specialize in helping clients navigate complex strategies like these. If you’re considering integrating life insurance into your defined benefit plan, we can help you evaluate the benefits, stay compliant, and build a plan that meets both your protection and retirement goals.
