Life Insurance Inside a Qualified Retirement Plan: The Quick Step Guide

As a defined benefit plan provider, we are big fans of qualified retirement plans. But did you know that you can purchase life insurance inside a qualified retirement plan?

This plan structure might not work for everybody. But for certain business owners who desire tax-deferred contributions and also want to fund life insurance, this can be a great option.

This article will discuss how this structure works and also point out some potential pitfalls. In implementing this, there are some essential points to note, but it can work great in the right situation. Let’s get started.

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An Alternative Funding Source

While qualified plans are superb retirement savings vehicles, they can also be used for the purchase of life insurance. Finding the funds to pay premiums is usually the biggest obstacle to selling life insurance. As an agent, closing the sale will be much easier if you can help find the funds to pay premiums without disrupting the policy owner’s lifestyle.

Qualified retirement plan funds can be a great source for premium dollars. Many qualified plans allow the trustee to purchase life insurance as an investment for the plan participants. When you understand how this works, you are able to educate clients on how to get a tax deduction for premium payments and still get the death benefit for their family.

Most people have three potential sources of funds to pay their life insurance policy premiums:

Personal FundsPremiums can be paid from salaries, bonuses, and other after-tax earnings or compensation. This alternative is straightforward. Life insurance premiums are an expense paid from funds left over after income taxes.
Business FundsBusiness owners and their key employees may be able to use business dollars to pay their premiums. The business can provide premium funds as an executive benefit to its key people, including top management, officers, directors, and highly compensated employees. For most other employees, there are other options than using business dollars.
Qualified Plan FundsEmployees who are participants in specific qualified pension and profit-sharing retirement plans may be able to have their plan trustee purchase and pay for their life insurance. Paying premiums through their qualified plan can make good financial sense. Many people need to be made aware of this possibility

Using a Qualified Plan to Pay Premiums Can Make a lot of Sense

The tax treatment of life insurance inside a qualified retirement plan usually provides an overall cost advantage compared to life insurance personally owned by the plan participant. This is because using personal funds is usually the most expensive way to pay premiums.

To use personal funds, the employee must use after-tax dollars. This means that the employee must earn more than that policy premium amount so that after taxes, sufficient dollars remain to pay the premium. The table below shows a simple example of the gross earnings required to provide enough funds to pay the stated premium.

What happens when life insurance is part of a qualified plan?

When the qualified plan trustee owns the policy and pays the premiums, the employee’s out-of-pocket cost is not the premium amount. Instead, the cost is the income tax due to the economic value of the pure life insurance coverage provided each year.

Generally, the economic value of this coverage increases each year as the employee gets older, and the cost to the employee is the additional income tax they must pay on it. This economic value is generally measured using IRS Table 2001, but it may be measured using the insurance carrier’s published one-year term rates in certain circumstances. It is this rate table and three variables that determine the employee’s annual out-of-pocket cost:

• Net death benefit payable to the employee’s beneficiary(ies)
• Employee’s age
• Employee’s marginal income tax bracket

When the Insured Is Rated or Uses Tobacco

Using qualified plan dollars to pay premiums is even more efficient when the insured is offered a rated policy. When your client applies for a policy, the insurer considers several factors, including tobacco products’ overall health and use. Policy premiums will be higher if your client uses tobacco products, or the insurer has concerns about their health.

If your client uses personal dollars to pay the premiums and is rated, they will have to earn more money to pay the premiums. On the other hand, if the qualified plan owns the policy and pays the higher premiums, the employee should be able to obtain the coverage without immediate impact on their cash flow and standard of living.

Life Insurance in a Qualified Retirement Plan Process

Putting life insurance in a qualified retirement plan, such as a 401(k), is not a common practice, as retirement plans are primarily designed to provide retirement benefits. However, some retirement plans may offer life insurance as an optional feature. Here are the general steps to follow:

  1. Check with your employer or retirement plan provider to see if the plan allows for life insurance as an option.
  2. Determine the insurance type and amount of insurance coverage you need. The coverage can be either term or permanent life insurance.
  3. Choose a life insurance provider that can offer coverage that fits your needs.
  4. Fill out the required paperwork to enroll in the life insurance coverage.
  5. Pay the premiums for the life insurance coverage through your retirement plan contributions.
  6. Remember that the premiums you pay for life insurance coverage will reduce the amount you contribute to your retirement plan, so you may want to adjust your contribution amount accordingly.
  7. Review your retirement plan and life insurance coverage periodically to ensure they continue to meet your needs.
How does a qualified plan work? 👉

The IRS established qualified plans decades ago to allow tax-deferred retirement growth. Employees and employers get immediate tax deductions for contributions that will then grow tax-deferred until retirement. The most popular type of qualified plan is a 401(k). However, defined benefit plans and cash balance plans are also considered qualified plans.

What are the advantages of having life insurance in a qualified plan? 👉

Insurance in a qualified plan can make a lot of sense if the employee has large life insurance deductions that they typically would pay out-of-pocket. This allows them to become taxed deductible once they are included in the plan. In addition, life insurance in a defined benefit plan can make a lot of sense if someone wants to make large contributions over the next several years.

What type of insurance can be included in a qualified plan? 👉

Qualified plans allow for whole life insurance, variable, life, universal life, and even term insurance. However, the incidental benefit rules work differently depending on the type of insurance utilized. The good news is the plan can be structured upfront to allow for the type of insurance desired and the amount of investments used in the side fund.

Different types of insurance

Term Insurance

Term life insurance is a particular type of life insurance that provides coverage for a specified term or period, ranging from one to 30 years. If the policyholder dies during the designated term, the death benefit is tax-free to the beneficiary.

Unlike permanent life insurance policies offering lifetime coverage and an investment component, term life insurance is a pure insurance product with no savings or cash value component. As a result, it typically offers lower premiums than permanent life insurance policies, making it an affordable option for many people.

Term life insurance is popular for people who want to ensure that their families are protected in the event of their unexpected death. It can be used to cover various expenses, such as mortgage payments, college tuition, or daily living expenses.

Term life insurance policies are also flexible and can be customized to meet the policyholder’s individual needs. They can be purchased in various amounts and for different term lengths, allowing policyholders to choose the coverage and term that best suits their financial situation and goals.

Whole Life Insurance

Whole life insurance is a type of permanent life insurance that provides lifetime coverage as long as the premiums are paid on time. It also has a savings or cash value component, which grows over time and can be used to borrow against or withdraw from. This means that whole life insurance policies offer both a death benefit and also a savings component, making it a comprehensive insurance and investment product. The premiums for whole life insurance policies are typically higher than term life insurance policies, as they provide lifetime coverage and a savings component.

Whole-life policies are designed to provide long-term financial protection and benefits, such as income replacement, debt payment, and estate planning. They also offer guaranteed cash value accumulation, which means that the policy’s savings component will continue to grow over time, regardless of market fluctuations.

Additionally, whole life insurance policies may also provide a level premium, meaning the premiums paid will remain the same throughout the policy’s lifetime. This provides a sense of stability and predictability for policyholders, as they can plan and budget accordingly for their insurance needs.

Variable Life Insurance

Variable life insurance is a particular type of permanent life insurance allowing policyholders to invest premiums in various investment options, such as mutual funds, stocks, and bonds. This investment component is known as the policy’s cash value, which can grow or decline based on the performance of the underlying investments.

The death benefit of a variable life insurance policy is also tied to the performance of the investment component, meaning that it can fluctuate based on the investment returns. As a result, variable life insurance policies offer both insurance protection and an investment opportunity.

Variable life insurance policies offer flexibility and control to policyholders, as they can choose how their premiums are invested and can adjust their investments over time. This allows policyholders to earn higher returns on their investments than with traditional whole-life insurance policies, but it also involves more risk. Due to the investment component, the premiums for variable life insurance policies are typically higher than those of traditional whole life insurance policies.

Policyholders should carefully consider their investment goals and risk tolerance prior to purchasing a variable life insurance policy and work with a financial professional to ensure that their investments align with their overall financial plan.

How does a qualified retirement plan work?

A qualified retirement plan is a retirement savings plan that meets specific Internal Revenue Service (IRS) requirements. These plans allow employees to save for retirement on a tax-advantaged basis, and employers can also make contributions on their behalf.

Several types of qualified retirement plans include 401(k) plans, 403(b) plans, and traditional pension plans. Each plan has its own set of rules and requirements, but they generally work in the following way:

  1. An employee decides to participate in the plan, and elects to have a portion of their salary contributed to the plan on a pre-tax basis.
  2. The employer deducts the designated amount from the employee’s paycheck and deposits it into the plan.
  3. The funds in the plan are then invested in various assets, such as stocks, bonds, or mutual funds, depending on the plan’s investment options.
  4. The contributions and earnings in the plan grow tax-deferred, meaning that the employee only pays taxes on them once they withdraw the funds in retirement.
  5. Employees can begin withdrawing funds from the plan when they reach retirement age. At this point, the withdrawals are taxed as ordinary income.

Qualified retirement plans are subject to various rules and regulations, including limits on contributions and withdrawals. Employers who offer these plans may also be required to meet specific eligibility and vesting requirements. It’s vital for employees to understand the particular rules of their plan and to regularly review their investments to ensure they are on track for a comfortable retirement.

Paul Sundin

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