For a small business owner, using qualified plan dollars to purchase life insurance protection is a strategy that can satisfy a variety of needs. It's also a step that can make all the difference in ensuring a smooth transitioning of the business upon the owner's exit. Using pre-tax dollars to purchase an asset that provides for a tax-free benefit can make the cost of life insurance protection much more affordable, but clients need to understand the different tax treatments that apply to life insurance when it is purchased through a qualified plan. Further, strict rules and limitations apply when life insurance is held in a qualified retirement plan, making it essential that your client has all the facts in order to ensure that a life insurance funding strategy is a success.
The Tax Benefits (and Complications)
While life insurance generally cannot be held within a retirement plan, an exception exists for life insurance policies that are held by qualified profit-sharing plans. This exception opens the door to a particularly useful strategy for small business owners because purchasing a permanent life insurance policy with qualified plan dollars can provide an attractive method for funding a buy-sell agreement that will govern in the event of a business owner's death.
While the premiums paid on a life insurance policy outside of a qualified plan may not be tax deductible, when the policy is held within the qualified plan, premiums are paid with pre-tax dollars. This can allow the client to purchase more life insurance protection than would otherwise be affordable and can lower the cost of insurance protection for a client that is in poor health and can qualify only for a more expensive policy.
The policy premiums are paid with pre-tax dollars, but it is important that the client understands the IRS will consider the pure cost of life insurance protection provided under the plan to be an economic benefit that is taxable income to the client. The cost of insurance protection that is taxable is calculated using IRS tables and is generally provided by the insurance company that issues the policy.
Further, if the client dies while still participating in the plan (i.e., prior to retirement), the portion of the proceeds that exceeds the policy cash value will be received tax-free, but the portion of the death proceeds that represents the cash value of the policy in excess of the basis in the policy is taxable.
The Incidental Benefit Rule
Though life insurance may be purchased with qualified plan assets, strict limitations imposed by the IRS require that the life insurance protection be only "incidental" to the retirement benefits provided by the plan. (Note that IRAs and Roth IRAs are not qualified plans and, as such, cannot be used to purchase life insurance protection).
In the case of a defined contribution plan, the IRS rules provide that if a whole life product is used, the premiums paid must represent less than 50% of the contributions that the client makes to the plan. Further, if a universal life product is used, the premiums paid must be less than 25% of the contributions that the client makes to the plan.
If defined benefit plan funds are used to purchase the policy, the client may elect to satisfy a different requirement, which provides that the life insurance is considered incidental if the client's death benefit is no more than 100 times that client's expected monthly retirement benefit.
Removing the Policy from the Plan
One possible downside to the strategy is that the life insurance policy may be held only within the plan while the client is a participant in the plan, which can create complications depending upon the client's circumstances at the time of retirement or plan termination.
