Use of Life Insurance Inside Retirement Plan

Qualified retirement plans offer many different investment options.  One option, which is often overlooked, is life insurance.  Under the right circumstances, life insurance can be an attractive investment option for a qualified retirement plan.

There are two basic types of qualified retirement plans.  The first is a defined contribution plan.  In this type of plan, the annual contribution is defined, but the ultimate benefit is not.  Annual contributions are based on a formula set forth in the plan document, generally a percentage of compensation.  Contributions are held in accounts established for plan participants and invested.  The amount of retirement income available to a participant depends upon the investment performance of his account.  401(k) and profit sharing plans are examples of a defined contribution plan.

The second type of qualified retirement plan is a defined benefit plan.  In this type of plan, the ultimate benefit is defined, but the annual contribution is not.  The annual contribution is the amount required to ensure that the plan has sufficient assets to fund the participant’s defined benefit at normal retirement age.  The annual contribution is actuarially determined and may fluctuate depending upon investment performance.  However, there is a type of defined benefit plan, known as a 412(e)(3) plan, where contributions do not fluctuate.  A 412(e)(3) plan is funded with guaranteed insurance company products.  Contributions to a 412(e)(3) plan do not fluctuate, because the investment return is guaranteed by the insurance company.  Investment options in a 412(e)(3) plan are more limited than in other defined benefit plans.

Both defined contribution plans and defined benefit plans may provide death benefits, as long as the death benefits are incidental to the primary purpose of the plan, which is to provide retirement income.  A plan’s death benefits can be funded with life insurance contracts.  The IRS has established two tests to determine whether a plan’s death benefits are incidental.  The first test limits the amount of plan assets spent on life insurance premiums.  This test is usually used in defined contribution plans.  The second test limits death benefits to an amount equal to 100 times the plan’s monthly retirement benefit.  Either test may be used in defined benefit plans.

The following are some of the benefits of using life insurance in a qualified retirement plan:

  • Additional benefit for employees
  • Income replacement
  • Protection from creditors
  • Death benefit may be received income tax fee (less tax on the fair market value of the policy’s cash surrender value)
  • Portable benefit
  • Employer provided death benefit may replace insurance paid for by employee
  • Higher benefit at death

Generally, a retirement plan may not provide a death benefit once a participant has attained normal retirement age and retired.  If the participant desires to maintain the life insurance protection, there are a number of options.  The plan can distribute the policy to the participant, who is then required to include the fair market value of the policy in taxable income.  Or, the participant can purchase the policy from the plan for its fair market value.  As long as the participant pays the fair market value for the policy, there should be no tax.

The rules regarding the use of life insurance in qualified retirement plans are complex.  RMC Group is here to assist you in helping your clients determine whether to include life insurance in their qualified plans.