Restrictions on Amount of Life Insurance in Qualified Retirement Plan: The “Incidental Benefit” Limitation

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You probably understand the tax-deferred benefits of qualified retirement plans. But what if you want to add life insurance into a qualified plan? You must understand the “incidental benefit” rules and the associated limitations and restrictions.

In general, the contributions can be used to buy almost any investments allowed by the trust agreement (to the extent allowed by law). However, there are limitations imposed on the types of benefits that can be included in a qualified retirement plan. The limitation on benefits will restrict or limit the amount of life insurance a company can have in a qualified plan.

In this post, we will examine the restrictions on the amount of life insurance that can be in a qualified retirement plan. We will also take a look at the “incidental benefit” limitations and give you some insight into how to structure a plan. Let’s get started!

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Some Background

The goal of a qualified plan is to provide participants with retirement income. If the IRS determines that the main purpose of a qualified plan is not for retirement benefits, the IRS can disqualify the plan. As such, all tax advantages would be gone.

Interestingly, there are no actual limitations within the Internal Revenue Code (IRC) on the types of assets that may be purchased by qualified plans. In fact, there are no specified limitations in section 401(a) concerning investment types that the plan trustee can purchase.

Qualified pension and profit-sharing plans are meant primarily to be a source of retirement benefits. Therefore, any benefit provided by a qualified plan that is not a retirement benefit, should be limited. In other words, such benefits should be “incidental” to the retirement benefit.

A pension plan is a plan established and administered by a company primarily to provide for the payment of determinable benefits to employees over the years, usually for life, after retirement. A pension plan can allow the payment of a pension due to disability and could also provide for incidental death benefit payments through insurance.

This imposed restriction is commonly referred to as the “incidental benefits” rule. The various standards the IRS has developed to measure and monitor such benefits are often called incidental benefits tests. But determining whether a particular level of death benefits is incidental and choosing which incidental benefits test to apply depends largely on the type of retirement plan.

Qualified plans fall under two broad categories: defined contribution plans or defined benefit plans. This classification is based on whether the plan specifies a company contribution rate or guarantees a specified benefit level. The IRS has developed different standards for applying the incidental benefits rule to each of these plan types.

Incidental Benefits for Defined Contribution Plans

Defined contribution plans provide benefits based on the establishment of individual participant accounts that are funded by pre-tax contributions from either the company or the plan participants (or both depending on plan type).

Because the actual benefit from defined contribution plans is indeterminate, the test used to determine whether the death benefits are considered incidental is based on the percentage of plan contributions that are used to purchase life insurance. This is commonly known as the percentage limitations test.

Under the percentage limitations test, death benefits in a defined contribution plan are considered incidental as long as:

  1. When whole life insurance is funding the death benefit, the premiums paid are less than 50% of the plan contributions for each plan participant;
  2. When the death benefit is funded using other types of life insurance (such as universal life insurance or term insurance), the premiums paid must be less than 25% of the contributions to the plan for each plan participant;
  3. Where the death benefits are funded using both whole life insurance and other types of insurance, the sum of one-half of the premiums paid for whole life insurance plus the full amount of premiums paid for other types of life insurance is less than 25% of the contributions to the plan for each plan participant; and
  4. The plan requires the trustee to convert the entire value of all life insurance contracts into cash or periodic income at or before each participant’s retirement and/or to sell or distribute each life insurance contract to the insured participant at or before retirement.

What Does the IRS Say?

The IRS ruled that the purchase of ordinary life insurance within a profit-sharing plan would be considered incidental when:

  1. the aggregate premiums for the life insurance in the case of each participant were less than one-half of the aggregate of the contributions allocated to him at any particular time; and
  2. the plan shall require the trustee to convert the entire value of the life insurance contract at or before retirement to provide periodic income so that no portion of such value may be used to continue life insurance protection beyond retirement.

The IRS has explained its reasoning from Rev. Rul. 54-51 by indicating that it considers a non-retirement benefit to be incidental to a qualified plan if the benefit cost is less than 25% of the total cost of the benefits provided by the Plan. The use of 50% of plan contributions to purchase ordinary (or whole life) life insurance contracts were considered incidental in Rev. Rul. 54-51 because the IRS deemed that “approximately one-half of the premiums paid for such policies are for pure insurance protection.”

As a result, under the percentage limitations test, purchasing life insurance to fund death benefits in a defined contribution plan is considered incidental as long as the aggregate premiums paid for ordinary (whole life) insurance are less than 50% of the total contributions or where the aggregate premiums paid for other types of life insurance (term life or universal life) are less than 25% of the total contributions.

Incidental Benefits for Split-Funded Defined Benefit Plans

Defined benefit plans are employer sponsored qualified pension plans that guarantee participants a specified benefit at retirement. Employers fund the promised benefits by making annual contributions to the plan.

The size of the deductible annual contributions is based on the amount of level contributions necessary to build the lump sum amount required to fund the promised benefit based on the number of years remaining until retirement age and on an assumed rate of investment return.

Annual contribution amounts may have to be adjusted depending upon the Plan’s actual investment experience: if return rates are greater than the assumed rate of return, annual contribution levels will decrease; if return rates are less than the assumed rate of return, annual contribution levels will increase.

What is the 100 to 1 rule life insurance?

The maximum annual benefit allowable for defined benefit plans is $195,000 (as of 2010). When death benefits are added to defined benefit pension plans and life insurance is purchased to fund such benefits, the plans are often referred to as “split funded” plans because funding for the plan benefits is split between life insurance and other investment assets.

The same basic rule applies to life insurance purchased inside split-funded defined benefit plans as is applied to defined contribution plans: death benefits from the purchase of life insurance will be considered incidental to the Plan if the cost of providing the death benefit is less than 25% of the total cost of funding all of the benefits provided by the Plan. With defined benefit plans, however, it is often easier to focus on the benefit amount provided than on the cost of funding the benefit (which may be dependent on investment experience).

Consequently, alternative tests have been applied to defined benefit pension plans: (i) the 100-to-1 Test,35, and (ii) the 1/3rd Test. 100-to-1 Test The most common Test applied to defined benefit plans is the 100-to-1 Test.

Under this Test, a death benefit is considered incidental within a defined benefit pension plan so long as the participant’s insured death benefit is no more than 100 times the anticipated monthly retirement benefit. The IRS has determined that the cost of providing such a death benefit will not exceed 25% of the cost of providing all benefits under the Plan. Based on the maximum annual benefit limitation of $195,000 (as of 2010), the maximum death benefit allowable under the 100-to-1 Test would be $1,625,000.

Understanding the 1/3rd Test

Defined benefit plans may also rely on the percentage limitations test typically applied to defined contribution plans. Death benefits for such plans will be considered incidental so long as premiums paid for the insurance are less than 25% of the cost of the Plan (50% if whole life insurance is used).

While this standard may not seem directly applicable to defined benefit plans because contributions are not allocated to participant accounts, the IRS has provided a method for doing so: To apply the “50 percent” rule of Rev. Rul. 74-307 to defined benefit plans, an amount representing the “employer contribution for a participant” must be computed.

This amount is the “theoretical contribution,” which is the contribution that would be made on behalf of the participant, using the individual-level premium funding method from the age at which participation commenced to normal retirement age, to fund the participant’s entire retirement benefit without regard to preretirement ancillary benefits.

The theoretical contribution is computed based on reasonable actuarial assumptions (i.e., interest rate, mortality) that must be stated in the plan. The “amount credited to the participant’s account at the time of death” for this purpose is the theoretical individual-level premium reserve computed using the theoretical contribution. The theoretical individual-level premium reserve is the reserve that would be available at the time of death if, for each year of plan participation, a contribution had been made on behalf of the participant in an amount equal to the theoretical contribution.

What is the best type of insurance for a qualified plan?

Even though you can use term insurance, that typically is not the best option because most of it will come back out in a 1099 based on the economic benefit. Most people use universal life or variable life even though the percentage contributions are lower.

Are you taxed based on the economic benefit of the insurance in the plan?

Yes. The employee participant will receive a 1099 for the insurance benefit they receive annually. This amount will change based on IRS tables. For this reason, you typically will not find term insurance placed into these plans. The small portion of term insurance will give you a contribution when it’s placed into the plan, but will come right back out to you as a 1099.

How do the incidental benefit rules work with life insurance?

The IRS allows life insurance in a retirement plan. However, it must be incidental to the benefits provided under the plan. Remember that qualified plans are established to provide retirement income for participants primarily. As such, premiums paid for life insurance will be limited.

Restricting the amount of life insurance included in a qualified plan

In applying Rev. Rul. 74-307 to defined benefit plans, the maximum premiums for ordinary life insurance may be no more than 66 (33 if term and/or universal life insurance) percent of the theoretical contribution. The death benefit payable may not exceed the face amount of the insurance policies plus the theoretical individual-level premium reserve less the cash value of the insurance policies.

The 1/3rd test can be applied to defined benefit pension plans using a three-step process:

First, the plan actuary calculates the annual contribution amount for the Plan, assuming that no life insurance will be used in the funding.

Second, 33% of this amount (66% if whole life insurance is used) may be used to purchase life insurance inside the Plan. Third, the total plan contribution amount is recalculated with the assumption that life insurance is one of the investments. The total permissible contribution amount will increase because the Plan is providing an additional benefit, and the contribution for life insurance should end up being approximately 25% of the new contribution amount (or 50% if whole life insurance is purchased).

Paul Sundin

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