Cash balance plans are one of the best retirement structures in the marketplace. They are one of the best tax deferral strategies for high-income business owners.
One twist on a traditional cash balance plan is adding life insurance to the plan. How does this work and when does this make sense?
It depends on a few criteria. But if you are looking to pay large life insurance premiums and want the added tax deductible component, it can be a great opportunity.
In this post, we will examine many of the pros and cons of including life insurance in a qualified plan. But more specifically, qualified plans will examine it in a cash balance plan. Cash balance plans are generally the number one defined benefit option used by plan administrators and businesses today.
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Some Background
Qualified pensions and profit-sharing plans were created by Congress to help employees accumulate assets for retirement and provide certain tax advantages for contributions made by employers.
Qualified Plans are subject to significant rules and regulations under the Internal Revenue Code (“IRC”) as well as to all of the complexities of the Employee Retirement Income Security Act of 1974 (“ERISA”). For example, Qualified Plans are subject to reporting and disclosure requirements, vesting and participation requirements, funding requirements, fiduciary responsibilities, and administration and enforcement requirements.
Thus, when considering what investments to use in a Qualified Plan, employers and plan participants should seek advice from tax or legal counsel, or seek the services of a third-party administrator (“TPA”).
Pros and Cons of Life Insurance in a Qualified Retirement Plan
Those considering the purchase of life insurance within a Qualified Plan must understand the “incidental benefit” limitations for various types of plan designs, ERISA and labor law limitations for purchasing life insurance in qualified plans, the tax treatment of life insurance protection while participating in a plan, the tax treatment of death benefits when paid out, and the options for continuing life insurance coverage at retirement.
- Provides for obtaining Permanent Life Insurance coverage through tax‐deductible contributions to the pension plan.
- An ancillary benefit available in addition to the normal retirement benefit.
- Provides for a higher tax‐deductible contribution limit over the life of the plan since the plan is funding both a retirement benefit and an ancillary death benefit.
- Provides for completion of family retirement planning in the event of premature death.
- Assuming survivorship until retirement, the insurance policy can provide for additional tax-free retirement income or can be used as an estate tax planning tool (assumes ultimate removal from the Pension Plan).
- All of the contributions are deductible to the plan sponsor. While covered by current life insurance protection, the current cost of the pure life insurance protection (using IRS Table 2001 rates) is reported as taxable income to the participant. This reportable economic benefit is generally small compared to the total contribution/deduction amount. For example, for an individual age 45 with a Death Benefit of $1,750,000 and an annual premium of $81,183, the first-year reportable economic benefit is approximately $950.
- Provides tax‐free insurance proceeds to beneficiaries in case of death. The plan is the owner of the policy. The plan provides an insured death benefit and the normal Pension Plan retirement benefits. If death occurs while the policy is inside of the Pension Plan, the death benefit is paid from the insurer to the Pension Plan. The Pension Plan then pays an amount equal to the death benefit less the policy’s cash value to the beneficiary income tax-free. The policy’s cash value plus additional assets from the plan brokerage account up to the Pension Plan retirement benefit could be rolled over to an IRA for the beneficiary.
- At or before retirement, the plan can permit the participant to purchase the policy from the plan for its fair market value. At retirement or termination of employment, the plan could distribute the policy to the participant. Once outside the Pension Plan, the insured can access the policy’s cash value via tax‐free loans or withdrawals to supplement retirement income. A Life Insurance Trust (ILIT) could similarly purchase the policy to help with estate tax planning and generational transfer purposes.
- Must provide insurance to some rank-and-file participants to satisfy benefits, rights, and features IRS requirements. If employee is an uninsurable or rated insurance level can be equivalent to that purchased by a premium for a standard class.
- Policies inside a Pension Plan have generally scheduled for 4 to 10 annual premiums.
The Incidental Benefit Rule
The IRS established qualified plans to provide retirement benefits to participants. They are a mainstay for retirement savings and include popular plans, like 401(k) plans, SEPs, and various defined benefit plan structures.
Even though these plans are set up for retirement, the IRS does allow a portion of retirement contributions to be allocated to life insurance. As such, the IRS put various rules in place to ensure that any life insurance benefits are incidental to the retirement benefits.
| Inside Plan | Outside Plan |
|---|---|
| Tax Deductible Insurance Premiums | After-Tax Insurance Premiums |
| Incidental Benefit Limitations | No Premium Limit |
| Taxable Economic Benefit | Tax-Free Death Benefit to Beneficiary |
| Split Funded Requirement | Cash Surrender Value |
The IRS actually does not limit the types of assets that could be purchased or acquired within qualified retirement plans. In fact, life insurance is not necessarily called into attention as an asset not allowed within the plan.
However, over the years, various court cases and IRS revenue rulings have clarified how much insurance can be in a qualified plan. In addition, there are two main retirement plan types: defined benefit plans and defined contribution plans. The IRS has broken out separate but similar rules for each different broad plan type.
The IRS-imposed limitations are commonly called the incidental benefits rule. A series of tests can also be applied, often called the incidental benefits tests. These tests are applied differently to different types of plans, depending on whether they are defined benefit or contribution plans.
A profit-sharing plan is considered a defined contribution plan. That’s because limitations are established annually based on specific criteria for plan contributions. Once a participant contributes an amount to the plan for that given year, they take the respective tax deduction, and it does not matter if assets go up or down. This is because the limits are established annually.
Because a profit-sharing plan does not establish a benefit at retirement, the test used to determine if insurance death benefits are considered incidental to the retirement plan is based on the percentage of plan contributions used to acquire the life insurance. This is often called the percentage limitations test.
Advantages of Life Insurance in a Qualified Plan
- Personal cash flow is improved: The employee doesn’t have to use personal out-of-pocket dollars to pay premiums.
- Tax efficiency is increased: Premiums are paid with pre-tax dollars; efficiency increases if the employee’s health is poor or the policy is rated.
- The employee doesn’t have to administer the policy: The plan trustee must administer it.
- The employee can obtain the desired life insurance coverage without worrying about the premium cost.
Disadvantages of Life Insurance in a Qualified Plan
- There is a cost for the coverage: The value of the pure term insurance element is taxable income annually.
- When the employee retires or changes jobs, the plan may not continue to be able to own the policy. Depending on the plan document’s provisions, it may have to be surrendered or transferred to the employee in a taxable distribution.
- When the qualified plan pays the employee’s life insurance premiums, the value of other investments in the account may be reduced, providing fewer assets for distribution during retirement.
- If the policy has cash value, the cash value portion will not be distributed income tax-free to the policy beneficiary. Instead, it remains in the plan and is distributed by the plan trustee to the employee’s designated beneficiary as ordinary income.
- The death benefits may be included in the employee’s estate for federal estate tax purposes.
Final Thoughts
Life insurance inside a qualified retirement plan offers a unique blend of protection and tax advantages—but it’s not for everyone. The ability to fund premiums with pre-tax dollars, grow cash value tax-deferred, and provide a death benefit can make it an appealing strategy, especially for business owners and high-income earners.
However, this approach comes with complexity. From the incidental benefit limitations to P.S. 58 cost reporting and potential tax consequences upon distribution, careful planning is essential. The key is to weigh the benefits against the administrative burden and compliance requirements.
If life insurance aligns with your broader retirement and estate planning goals, it can be a powerful tool when structured correctly. At Emparion, we specialize in advanced retirement strategies and can help you evaluate whether this option fits your needs. With the right guidance, you can turn complexity into opportunity.
