Administering defined benefit or cash balance plans can be challenging. This is especially true when life insurance is included in the plan.
But what should you be aware of while working with clients on the complexities of life insurance in defined benefit plans?
In this post, we will discuss administration aspects that are specific to insurance in plans. We also offer some tips and suggestions to ensure the plan remains compliant. Let’s jump in!
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Some background
The purpose of this article is to discuss the administrative tasks. For this purpose, we will assume that the plan meets the incidental benefit rule and any other compliance issues that govern the type and amount of insurance that can be included in the plan.
The goal is for the administrator to gain a better understanding of some of the compliance issues. But we will give you a brief summary of some of the rules.
The Plan Document Must Allow Insurance
Make sure the plan allows for investments in life insurance; otherwise, it may lead to an operational failure.
Most plans include a statement similar to the following: “The plan administrator shall procure life insurance according to a uniform, non-discriminatory policy that is consistently applied.” It is advisable to review this policy with the administrator to ensure they are regularly applying for new policies for new participants and adjusting existing policies as needed to maintain a non-discriminatory approach.
All eligible employees must have life insurance
Most plans have restrictions based on the number of hours worked, age, and entry dates. Once they meet the eligibility criteria, they will be entered into the plan.
If the plan is a cash balance plan, then only 40% of eligible employees have to be included in the plan. Of course, the plan must meet the non-discrimination testing and other tests. Therefore, it’s likely that a contribution will still need to be made on the profit-sharing side of the plan.
However, when insurance is included in the plan, all employees must be covered by insurance. The only exception to this is if the employee waives the insurance requirement.
Remember that when an employee receives insurance, they will receive a Form 1099-R at the end of the year. Most employees will struggle to understand why they received this. Even though you can explain it to them, they are unhappy that this results in a taxable transaction for them, and it increases their tax burden. Of course, if they do not receive an insurance allocation, they won’t receive a 1099-R.
1099-Rs will confuse and often anger non-owner employees. As such, make sure the issue is discussed up front with the business owner and either: (1) the employees are educated on how it works; or (2) the employees sign a waiver.
PS-58 Costs and Filing 1099s
To ensure that the net proceeds from a life insurance policy are tax-free, the participant must pay a tax according to Revenue Ruling 55-757 and subsequent regulations. Most, if not all, insurance companies that offer qualified plan products will inform the insured about both the cost of current life insurance protection and the Schedule A information needed for Form 5500. This information can also be obtained from the servicing agent of the policy.
If this information is not readily available, the IRS has published Table 2001, which can be found in Revenue Rulings 2001-10 and 2002-8. The taxable cost for the insured is generally significantly higher in Table 2001, so it is best to acquire this information directly from the insurance company.
These costs are typically reported as taxable income to the participant each year, usually through Form 1099-R. There may be disputes among service providers regarding who is responsible for generating this 1099-R, so it is advisable for the servicing third-party administrator (TPA) to generate and charge for it.
To understand these rules better, see this article: Tax Treatment of Life Insurance to Participant
Fair Market Value of Insurance
It is common to report the value of life insurance or other insurance contracts based on their cash surrender value. However, many insurance contracts impose significant surrender charges during the initial years of the contract.
To address this issue, the IRS issued Revenue Procedure (Rev. Proc.) 2005-25, which provides guidance on establishing the fair market value of insurance contracts during distributions. This guidance was implemented to prevent abusive practices by insurance companies that offered specially designed “springing cash value” policies. Since the issuance of this guidance, many insurance companies have developed specialized product lines for qualified plans.
If you are working on a plan that involves life insurance, whether it is a Defined Benefit (DB) or Defined Contribution (DC) plan, you must request a complete copy of the entire insurance contract—no exceptions. This is similar to requesting the entire brokerage statement for any plan asset rather than just obtaining the year-end value in an email from an advisor.
Having access to the entire contract will provide you with all current and projected market values. Most importantly, it will indicate whether the contract is intended to be held within a qualified plan. If it is not a qualified plan product, there is a 99% chance it will have compliance issues. These issues may include improper market valuation under Revenue Procedure 2005-25, the inclusion of long-term care and disability riders not specified in the plan document, and unisex mortality in underwriting.
IRC Section 415: Limits on Benefits and Formulas for Death Benefits
The definition of the death benefit should be carefully considered in the plan to avoid any operational defects. To fully capitalize on the death benefit as a lump sum, the plan’s definition should include the present value of the accrued benefit plus the proceeds from life insurance, without deducting the cash surrender value.
Is a Cash Balance or Defined Benefit Plan Right For You?
This scenario is most common in small plans, particularly those designed for just husband and wife. According to Internal Revenue Code (IRC) Section 101, life insurance proceeds are generally exempt from income tax, and qualified plans are included in this exemption as long as the PS-58 tax is accounted for as described.
It’s important to note that under IRC Section 415, if the death benefit is considered incidental, then the death benefit is not subject to the limitations set forth in IRC Section 415.
However, this does not mean that the life insurance contract is exempt from IRC Section 415 before the death of the participant, especially regarding the distribution of the contract for its cash surrender value. The limitations of IRC Section 415 do not apply when a participant passes away, and the insurance proceeds are disbursed in addition to the present value of accrued benefits. It’s important to remember that the Present Value of Accrued Benefits (PVAB) remains subject to IRC Section 415.
Nondiscrimination Testing
There can be challenges when testing life insurance and the associated death benefit under IRC Section 401(a)(4) and the relevant regulations, particularly concerning benefits, rights, and features. Previously, organizations could demonstrate compliance when submitting a plan for qualification to the IRS, and they could receive a favorable determination from the agency in this regard. However, the process has changed, and the IRS no longer issues rulings based on these demonstrations.
To our knowledge, there is no established procedure or ruling for testing the death benefit for covered employees. Death benefits and insurance are considered ancillary benefits that must be currently available and effectively accessible to a non-discriminatory group of employees. Unlike retirement benefits, there is no clear numerical test for this assessment.
The most conservative approach for a defined benefit (DB) plan is to adopt a safe harbor design and ensure that the underlying death benefit applies to all participants. There are more aggressive designs available, where one can purchase insurance to aggregate benefits between a defined contribution plan and a defined benefit plan, while attempting to reasonably demonstrate non-discrimination under a general testing approach.
Some might argue that as long as the insurance coverage is available for all participants, a numerical test is unnecessary. However, according to Treas. Reg. §1.401(a)(4)-1(c)(2), all non-discrimination regulations must be interpreted in a reasonable manner that aligns with the purpose of preventing discrimination.
Exit Strategies
One of the biggest challenges in maintaining life insurance within a defined benefit (DB) plan is the “end-game.” In the small plan market, there often comes a time when the owner has fully accrued their benefits, as allowed under IRC Section 415. At that point, it is typically recommended to terminate the plan.
Unlike annuity contracts, life insurance contracts cannot be rolled over into individual retirement accounts (IRAs), which is generally the preferred option for such participants.
There are generally three options for terminating a defined benefit plan regarding life insurance:
- Surrender the Life Insurance. The proceeds from the surrendered life insurance policy go to the plan’s trust.
- Distribute the Life Insurance to the Plan Participant. The policy can be distributed to the participant based on its fair market value. This distribution is taxable to the participant and equals the cash value minus the accumulated PS58 costs paid by the insured throughout the life of the plan.
- Purchase the Policy by the Insured. The insured may buy the policy from the plan using after-tax dollars for its fair market value, which may be close to or equal to the cash surrender value. It is advisable that any policy owned by the plan should be issued by an insurance company that provides a qualified plan product, as permitted under PTE 92-06. This purchase can occur either before or after taking a maximum policy loan and should consider the accumulated value of PS58 costs paid to ensure tax efficiency.
- Rollover the Insurance to Another Qualified Plan. The insurance can be rolled over into another qualified plan, such as a profit-sharing or 401(k) plan. When doing this, it’s important to consider any necessary contract changes, especially if future premiums will not be paid in the defined contribution (DC) plan.
Bottom Line
Successfully administering life insurance as part of a defined benefit plan requires careful attention to both regulatory compliance and operational integrity. Ensuring that the plan document explicitly permits life insurance, maintaining ongoing incidental benefit testing (such as the 100× rule), and accurately reporting the participant’s annual economic benefit are all critical steps. Moreover, selecting a reputable third-party administrator (TPA) experienced with these complexities can mean the difference between maintaining plan qualification and risking costly tax issues.
Ultimately, while retirement benefits with life insurance offers valuable flexibility—such as securing legacy protections and enhancing benefit completeness—these advantages come with administrative and tax nuances that cannot be overlooked. By staying proactive in plan governance, documentation, and participant communications, sponsors can blend insurance effectively and sustainably into their defined benefit structure—producing long-term benefits without compromising compliance or fiduciary duties.
