Life insurance has long been a permitted, if heavily regulated, feature inside qualified retirement plans. The general framework imposed by the IRS treats insurance as an “incidental” benefit—something the plan can offer in support of its primary retirement purpose.
For most plans, that means strict percentage caps on how much of a participant’s account can be used to pay insurance premiums. Profit sharing plans, however, enjoy an exception that defined benefit plans do not. That exception is built around the concept of “seasoned money,” and it operates through two related rules: the 2-year rule and the 5-year rule.
This post will discuss these rules and offer a few tips. Let’s dive in!
The Baseline: Incidental Benefit Limits
Before the seasoned money rules can be appreciated, the underlying limits need to be understood. Under longstanding IRS guidance, premiums paid from plan assets to fund life insurance on a participant generally cannot exceed certain percentages of the employer contributions allocated to that participant’s account.
For ordinary whole life insurance, premiums are capped at 50% of cumulative employer contributions. For universal life policies, the cap drops to 25%. These limits exist so that a qualified plan does not morph into a vehicle whose dominant economic purpose is delivering tax-favored death benefits rather than retirement income.
In defined benefit plan, those caps apply to the entire account or accrued benefit, period. There is no relief for older contributions. In a profit sharing plan, the analysis changes dramatically once contributions have aged.
The 2-Year Seasoned Money Rule
The 2-year rule is straightforward. Employer contributions that have been in a profit sharing plan for at least two years can be used to purchase life insurance. Said differently, once “seasoned” those dollars can be used to purchase life insurance without being counted against the 25% or 50% limits.
Under this rule, only contributions made within the most recent two years remain subject to the percentage limitations. The plan administrator must track contribution dates carefully, because the seasoning calculation is essentially a rolling test applied against each tranche of employer money.
Two important points to note:
- If the profit-sharing plan is a 401(k) plan, employee deferrals cannot be used under this rule because they are not profit-sharing contributions.
- Under the 2 year rule, only contributions can be allocated to life insurance and not investment earnings.
The 5-Year Seasoned Money Rule
The 5-year rule is the more powerful of the two rules. Under this rule, if a participant has been in the profit sharing plan for at least five years, all funds in their account (regardless of when each contribution was made) are considered seasoned and fall outside the incidental benefit limitations entirely.
Three important points to note:
- Just like the 2 year rule, if the profit-sharing plan is a 401(k) plan, employee deferrals cannot be used under this rule because they are not profit-sharing contributions.
- As long as 5-year participation has been met, all contributions can be used for life insurance even contributions made within the past two years.
- In contrast to the 2-year rule, once 5 year participation is met, the entire account balance (even investment earnings) can be used to purchase life insurance.
Practical Implications for Plan Design
For participants, the seasoned money rules change the economics of using a profit sharing plan to fund life insurance. A participant who has been in a plan for six or seven years and has accumulated substantial seasoned money may be able to purchase a meaningful policy. The premiums are paid by the trust, the policy is owned by the trust, and the death benefit ultimately flows to the participant’s designated beneficiary.
This planning technique is sometimes used to layer survivor protection on top of retirement accumulation, or to facilitate buy-sell funding in closely held business contexts. It can also be a component of a broader strategy where the policy is eventually distributed to the participant or sold to them at fair market value at retirement.
Important Caveats
Several considerations temper the appeal of these rules. First, the participant must include the annual economic benefit of the pure insurance protection in current taxable income each year, calculated using the IRS Table 2001 rates (or the insurer’s lower term rates if available).
This “PS-58 cost” reduces the apparent tax efficiency of the arrangement. Second, plan documents must specifically permit the purchase of life insurance, and the trustee has fiduciary responsibilities under ERISA that go beyond the bare tax rules.
Third, the policy itself must be properly handled at retirement—either distributed, surrendered, or purchased out of the plan—to avoid unfavorable tax results. Fourth, the seasoning rules require careful recordkeeping; a plan that cannot document when contributions were made will struggle to support its position on audit.
Finally, while the seasoned money rules are well-established, they are creatures of revenue rulings and private letter rulings rather than statute or regulation. Practitioners generally treat them as reliable, but plan sponsors should engage qualified ERISA counsel and tax advisors before relying on them for any significant insurance funding strategy.
Final Thoughts
The 2-year and 5-year seasoned money rules represent a meaningful, profit-sharing-specific exception to the otherwise rigid incidental benefit limits on life insurance in qualified plans. Used thoughtfully, they allow long-term participants to fund substantial coverage through plan dollars in ways that would be impossible in a money purchase or defined benefit context.
Used carelessly, they can create administrative headaches and unwelcome surprises at distribution. As with most advanced retirement planning techniques, the value lies in the execution, and qualified professional guidance is essential.
