Why You Should Include Life Insurance in Your Qualified Retirement Plan

By Mary Read CPC, QPA, CPFA, and Anthony Competelli


There is always the risk of dying prematurely. Life insurance can make a plan self-completing in the event of premature death, ensuring the retirement benefits that participants planned to have for retirement will be there for beneficiaries.

There may also be needs for life insurance outside the qualified retirement plan that can be met by buying insurance in the plan at a lower cost. All premiums paid for life insurance in a qualified plan are paid with tax-deductible plan contributions.

In defined contribution plans, the employer can choose to include insurance in the plan either by requiring coverage to be provided to each plan participant or by offering the insurance and allowing participants to choose whether they want the insurance. Also, premiums are paid out of the dollars contributed.

When life insurance is included in defined benefit plans, all participants must be provided with the insurance. The addition of life insurance in a defined benefit plan will increase the plan contribution by an actuarially determined amount. This is good news for some employers who are seeking the maximum possible deductible plan contribution.

Is There a Cost to the Employee for the Life Insurance?

Whenever life insurance is included in a qualified retirement plan, the insured is receiving an immediate benefit in the form of the life insurance protection. The value of this benefit is reported and added to the insured’s taxable income each year.

The amount reported is not the actual premium but is an “economic benefit” cost for the pure death benefit coverage. Pure death benefit coverage is the difference between the death benefit provided by the life insurance policy and the cash value of the policy.

The “economic benefit” reported is determined using IRS Table 2001 (IRS Notice 2001-10) or, if the insurance company that issued the policy meets requirements defined by the IRS, the company may use its own term insurance rates. The insurance company will provide this information to the company sponsoring the plan each year.

How Much Insurance Is Allowed?

Insurance must be incidental to any qualified retirement plan. Insurance is incidental if these rules are followed.

Of plan contributions to defined contribution pension plans, these amounts may be used to pay premiums:

  • Up to 25% of aggregate contributions for universal life insurance
  • Less than 50% (49.99%) of aggregate contributions for whole life insurance

Profit sharing plans have more generous rules that also apply. They can use 100% of these amounts to pay premiums:

  • Funds including earnings accumulated in the account for over two years
  • A participant’s entire account after five years of plan participation
  • Funds rolled over from an IRA

With defined benefit pension plans, the amount of insurance must meet one of these two limits:

  • The death benefit equals no more than 100 times the projected monthly pension amount. For example, if the participant will receive a $1,000 monthly benefit, the maximum face amount of life insurance can be $100,000.
  • Or, Rev. Ruling 74-307 Percentage Test (Percentage of Theoretical Uninsured Cost), where up to 66.6% of the theoretical uninsured cost may be used for the whole life insurance premium, or up to 33.3% of the theoretical uninsured cost may be used for the universal life premium.

What Happens to the Life Insurance Policy at Retirement?

At retirement the life insurance policy must be removed from the qualified retirement plan. This can be accomplished in four ways: surrendering the contract, distributing the contract, purchase, or exchange.

When the contract is surrendered, the death benefit is eliminated, and the cash value remains in the plan and can be rolled to an IRA or taken as cash.

When the contract is distributed, the death benefit and cash value are preserved. Also, tax is paid on the fair market value minus the reportable economic benefit.

When the contract is purchased, the participant pays the fair market value of the policy to the plan in cash, and the policy ownership is changed to the participant. Also, the death benefit and cash value remain with no taxation.

Some insurance companies offer an exchange, where the policy may be surrendered in the plan, leaving the cash value in the plan to be rolled to an IRA or distributed as cash. A new contract is then issued on the insured outside the plan.

What Benefits Are Paid at Death?

If an insured participant dies while he or she is in the plan, the insured’s beneficiary will receive the benefit that he or she has accrued in the plan, plus the life insurance death benefit. With no life insurance, the beneficiary would receive only the benefit accrued in the plan at the time of death.

When life insurance is included, the pure death benefits provided by the life insurance will be paid income tax-free. The cash value of the policy and any accrued benefit paid will be subject to income tax. The “economic benefit” costs paid over the life of the policy may be claimed as cost basis against the taxable cash value of the policy.

What Is a Fully Insured 412(e)(3) Plan?

A 412(e)(3) plan is a defined benefit plan defined under Section 412(e)(3) of the Internal Revenue Code. The plan may be funded only with guaranteed level premium annuity contracts and level premium whole life insurance. Individual contracts are issued on each plan participant, and minimum guarantees are provided in the contracts, eliminating market risk.

Because funding of the benefits is based on the guarantees in the contracts, fully insured 412(e)(3) plans frequently generate the largest deductible plan contributions. 412(e)(3) plans were formerly known as 412(i) plans. Originally established under section 412(i) of the Internal Revenue Code, they were moved to Code Section 412(e)(3) by the Pension Protection Act of 2006.

Ms. Read is national director of pension and protection planning at Pentegra Retirement Services and partner of M&R Business Development Group. A leading authority in qualified retirement plans with more than 30 years’ experience, she has an extensive background in plan design and development and experience as a marketing executive, financial professional, pension analyst, and pension compliance manager. She is a frequent speaker on qualified plans and contributor to industry publications. And, she is the author of three books.

Mr. Competelli is president and CEO of National Retirement Group and a former BENCOR regional manager. He is a graduate of the State University System of New York at Farmingdale with a degree in finance. He started his own corporation, Financial Reserve Services, in 1990, which he sold to USRP in December 2009. He began working with BENCOR in 2005. He also is a certified tax preparer through AARP, volunteering with local chapters of the Lighthouse of the Blind in preparing tax returns. For more information, contact financialfocus100@gmail.com.

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