Is Life Insurance a Good Fit in Qualified Plans?

As the stock market continues to slide, so does the average 401(k) account.  Some 401(k) accounts have lost as much as 25% in value since the beginning of the year.  That means that an account that had a $135,000 balance on January 1, 2022, is now worth about $101,000. This has left many plan participants wondering if they made a mistake participating in their 401(k) plan in the first place. Younger participants may be able to wait the market out until it recovers, but what about those who are close to retirement?

Business owners who are relying on 401(k) plans are in the same position as their employees.  They are also wondering what to do about their own retirement plans.

There are other options for your retirement plans that most people are unaware of. This includes adding life insurance to your retirement plan. In this article we are going to discuss the benefits, why you should add it, and how to add it.

Benefits to Adding Life Insurance

There are a number of benefits to adding life insurance to a retirement plan, including:

• Premiums are paid from tax-deductible contributions to the plan
• Contributions to a qualified retirement plan are not taxed to the participant until a benefit is paid
• Earnings grow tax-deferred
• Life insurance is a benefit that helps an employer attract and retain employees
• Life insurance provides additional financial support to the family of a participant who dies before normal retirement age

Life insurance can be used in both defined contribution and defined benefit plans.  It must be offered on a uniform and nondiscriminatory basis. However, the Internal Revenue Code imposes certain limitations on the use of life insurance in qualified retirement plans.

Types of Retirement Plans

There are two main types of retirement plans: defined contribution plans and defined benefit plans.

In a defined contribution plan, employees, and maybe their employer, make contributions to the plan.  Each employee has their own account in the plan.  How much money an employee will have at retirement will depend on the investment performance of their account.

Defined contribution plans include the traditional 401(k) plan and its relatives, the Roth 401(k) and the Safe Harbor 401(k).

In contrast, a defined benefit plan defines a participant’s final benefit based on a formula in the plan documents.  The employer alone makes contributions to the plan.  The employer must make annual contributions in an amount actuarially-determined to be sufficient to pay for the plan’s benefits.

Defined benefit plans include the traditional defined benefit plan and its relatives, the cash balance plan and the 412(e)(3) fully-insured plan.

Life Insurance in Defined Contribution Plans

A defined contribution plan can be funded with life insurance.  However, the life insurance must be “incidental” to the plan’s main purpose of providing retirement benefits to the plan’s participants.

So, is there a limit on the amount of life insurance in a defined contribution plan? Yes, there is a limit on the amount of plan assets that can be used to pay insurance premiums. The amount that a plan can spend on insurance premiums depends upon the type of insurance policy:

• Whole Life Insurance – the premiums cannot exceed 50% of total contributions to the plan, including participant 401(k) deferrals and employer contributions, but excluding investment earnings.
• Term or Universal Life Insurance – the premium cannot exceed 25% of total contributions.

Special Rules:

• Plan assets that are older than two years may be used to pay life insurance premiums with no limitation. However, the use of “old money” may be considered a taxable distribution to the participant.
• Employee after-tax and rollover contributions must be in the plan before they can be used to pay life insurance premiums.
• The “economic value” of a plan’s death benefit is taxable to a participant. The taxable income is calculated using IRS Table 2001.

Life Insurance in Defined Benefit Plans

Life insurance can be used in both traditional defined benefit plans and fully-insured 412(e)(3) plans. Unlike defined contribution plans, when life insurance is offered in a defined benefit plan, it must include all participants.

Traditional Defined Benefit Plans:

• 50% test – the premiums may not exceed 50% of total contributions
• 100-to-1 rule – the face value of the policy is limited to a maximum of 100 times the participant’s monthly retirement benefit

412(e)(3) Plans:

• Like a traditional defined benefit plan, a 412(e)(3) provides a defined benefit based upon a formula in the plan document
• 412(e)(3) plans are funded exclusively with guaranteed annuity contracts or a combination of annuity contracts and whole life insurance
• Because they’re funded with annuity contracts or a combination of life insurance and annuity contracts, there’s no full funding limitation
• 412(e)(3) plans do not require an actuarial valuation, and have lower administration fees
• 412(e)(3) plans are not subject to market volatility because the benefit is guaranteed by the insurance company
• 412(e)(3) are always fully funded because premiums have to be annually, and the plan’s benefits are guaranteed by the insurance company as long as premiums are paid
• 412(e)(3) generally require larger contributions than a traditional defined benefit plan, especially in early years

A Closer Look at 412(e)(3) Plans

412(e)(3) plans are great for small business owners, especially those who are close to retirement or have not adequately provided for their retirement. They can be fully funded in a relatively short period of time.  They generally require larger tax-deductible contributions.  More importantly, they eliminate any market risk.  The benefit is guaranteed by the insurance company, assuming all premiums have been timely paid.  A business owner thereby transfers investment risk to the insurance company.

However, a 412(e)(3) plan must be done right and must meet all of the following six requirements:

1. The plan must be funded exclusively by the purchase of annuity contracts or a combination of life insurance and annuity contracts.
2. The contracts must be bought from an insurance company licensed in the United States to do business with the plan.
3. The annuity and/or insurance contracts must provide for stable annual premium payments beginning on the date each individual begins participating in the plan and ending no later than the normal retirement date of that individual or, if earlier, the date the individual stops participating in the plan.
4. The benefits provided by the 412(e)(3) plan must equal the benefits provided by the annuity and/or insurance contracts. In addition, the insurance company must guarantee the benefits.
5. Premiums payable for the plan year and all prior plan years under the contracts must have been paid in full.
6. No rights under the annuity or insurance contracts may be subject to a security interest at any time during the plan year.

A 412(e)(3) plan can be funded solely with annuity contracts or a combination of life insurance and annuity contracts.  If life insurance is used in the plan, the life insurance is limited to an amount considered “incidental” to the plan’s main purpose, which is to provide retirement benefits to participants.

Conclusion

Life insurance can be used effectively in both defined contribution plans and defined benefit plans. It is especially appropriate in 412(e)(3) plans.  However, using life insurance in any type of qualified retirement plan requires careful planning and an understanding of the rules regarding its use.

We, in the Pension Division of RMC Group, specialize in working with advisors who serve the small plan market and its participants. We can help you navigate the rules regarding the use of life insurance in a qualified retirement plan and help you market and explain to your business clients how life insurance in a qualified retirement plan, especially a 412(e)(3) defined benefit plan, can help them ensure sufficient and stable retirement income. With our help, you can shine by showing your clients the many benefits of including life insurance in their retirement planning.

Call 239-298-8210 or visit our website at rmcgp.com to see how we can partner with you to help your clients understand how funding their retirement with life insurance products can be beneficial.