Life insurance plays specialized roles in retirement planning, providing death benefit protection within certain qualified plans and serving as funding vehicles for non-qualified deferred compensation. Understanding the rules and restrictions is essential for proper planning.
ERISA-governed, tax-favored retirement plans:
Characteristics: - Tax-deductible contributions: Employer deducts contributions - Tax-deferred growth: Earnings not taxed until distributed - ERISA rules: Subject to Employee Retirement Income Security Act - Non-discrimination: Must cover broad employee base - Contribution limits: Annual IRS limits - Required distributions: RMDs starting age 73
Types: 1. Defined benefit plans (pensions) 2. Defined contribution plans (401(k), profit-sharing, money purchase) 3. 403(b) plans (tax-sheltered annuities for nonprofits) 4. 457 plans (deferred compensation for government/nonprofit)
Personal retirement savings: - Traditional IRA: Tax-deductible contributions, taxable distributions - Roth IRA: After-tax contributions, tax-free distributions - SEP-IRA: Simplified Employee Pension (employer contributions) - SIMPLE IRA: Savings Incentive Match Plan (small employer)
Not subject to ERISA: - Deferred compensation: Promise to pay in future - Executive benefits: Selective, for key employees - No current deduction: Employer deducts when paid - Flexible: Not bound by qualified plan rules
Life insurance is permitted in some qualified plans:
Allowed in: - ✓ Defined benefit plans (pensions) - ✓ Profit-sharing plans - ✓ 401(k) plans - ✓ Money purchase pension plans
Not allowed in: - ✗ IRAs (traditional or Roth) - ✗ SEP-IRAs - ✗ SIMPLE IRAs
Life insurance must be incidental to retirement savings:
Cannot be primary purpose: - Primary purpose: Retirement income - Life insurance: Incidental death benefit protection - Limits apply: Strict percentage limits
Limits on life insurance premiums in qualified plans:
50% Test:
Life insurance premiums ≤ 50% of total contributions
Example:
Total contributions to participant account: $100,000
Maximum for whole life premiums: $50,000 (50%)
Remaining for retirement investments: $50,000
25% Test:
Term insurance premiums ≤ 25% of total contributions
Example:
Total contributions: $100,000
Maximum for term premiums: $25,000 (25%)
Remaining for retirement: $75,000
Treated as whole life (50% test)
Example - Combined:
Annual contribution: $20,000
Whole life premium: $10,000 (exactly 50%)
Invested in mutual funds: $10,000
Total: $20,000
Meets 50% test: Yes
Alternative test for death benefits:
Death benefit cannot exceed:
Death Benefit ≤ 100 × Projected Monthly Retirement Benefit
Example:
Projected monthly retirement benefit: $3,000
Maximum death benefit: $3,000 × 100 = $300,000
If death benefit > $300,000: Violates rule
Annual taxable income to participant:
Imputed income: - Economic benefit: Value of pure insurance protection - Table 2001 rates: IRS table (formerly PS-58) - Taxable annually: Reported as income each year - Only term portion: Cost of pure protection, not cash value
Formula:
Annual Taxable Amount = (Death Benefit - Cash Value) × Table 2001 Rate
Example:
Participant: Age 45
Death benefit: $500,000
Cash value: $50,000
Table 2001 rate (age 45): $1.53 per $1,000
Net amount at risk: $500,000 - $50,000 = $450,000
Annual PS-58 cost: ($450,000 ÷ $1,000) × $1.53 = $688.50
Participant reports: $688.50 as taxable income (annually)
Pays income tax on: $688.50
Economic benefit doctrine: - Current benefit: Participant receiving death benefit protection now - Not deferred: Protection is current, not deferred to retirement - Must recognize: IRS requires annual income recognition
Options when participant retires or terminates:
Taxable amount formula:
Taxable = Cash Value - Cumulative PS-58 Costs Already Paid
Example:
Cash value at distribution: $80,000
Cumulative PS-58 costs paid over years: $15,000
Taxable income: $80,000 - $15,000 = $65,000
Participant pays tax on: $65,000
If participant dies before retirement:
Amounts paid to beneficiary: - Account value: Taxable as ordinary income (qualified plan distribution) - Life insurance proceeds: Income tax-free (IRC §101(a))
Example:
Death occurs:
Account value (investments): $200,000
Life insurance death benefit: $500,000
Total to beneficiary: $700,000
Tax treatment:
- Account value: $200,000 (taxable as ordinary income)
- Insurance proceeds: $500,000 (income tax-free)
Beneficiary owes tax on: $200,000 only
Receives tax-free: $500,000
IRC §408 - Life insurance not allowed:
Cannot hold in IRAs: - ✗ Traditional IRA - ✗ Roth IRA - ✗ SEP-IRA - ✗ SIMPLE IRA
Reason: IRAs designed exclusively for retirement savings, not life insurance
Permitted: - ✓ Annuity contracts (provide retirement income) - ✓ Stocks, bonds, mutual funds - ✓ Real estate (self-directed IRA)
Allowed: - Annuity contracts: Provide life-contingent income - Not life insurance: Focus on retirement income, not death benefit - Tax-deferred: Grow tax-deferred in IRA
Types: - Fixed annuities - Variable annuities - Indexed annuities - Immediate annuities (at retirement)
Permitted but uncommon:
Structure: - After-tax contributions: Typically funded with after-tax employee contributions - Separate account: Life insurance in separate sub-account - Participant choice: Optional, not mandatory - 50/25% test applies: Must meet premium limitations
Example:
401(k) participant:
Pre-tax deferrals: $15,000 (goes to mutual funds)
After-tax contributions: $10,000 (funds life insurance)
Whole life premium: $10,000
Total after-tax contributions: $10,000
Meets test: Yes ($10,000 is ≤ 50% of total contributions)
Pension plans funded entirely with insurance:
Characteristics: - 100% insurance/annuities: All assets in insurance contracts - Guaranteed benefits: Insurance company guarantees benefits - Level premiums: Fixed annual premiums - Predictable: No investment risk - Higher contributions: Typically higher than other pension plans
Used for: - Small business owners - Professional practices - Older owners (catch-up)
Example:
Small business: 3 partners, age 55
Want: Guaranteed pension benefits
Fund with: Life insurance and annuities
Annual contributions: $150,000
Guaranteed retirement benefit: $5,000/month at age 65
Death benefit: $1 million per partner
Informally funded:
Structure: - Employer promise: Agreement to pay benefits in future - Corporate-owned life insurance (COLI): Employer owns policy on executive - Employer = owner and beneficiary: Controls policy - Not plan asset: Executive has no rights to policy - Helps fund: Provides cash to meet future obligation
Example:
Executive age: 45
Deferred comp agreement: $100,000/year for 15 years at retirement
Present value: ~$800,000
Employer buys COLI:
Insured: Executive
Owner: Corporation
Beneficiary: Corporation
Face amount: $2 million
Premium: $30,000/year
At retirement:
Cash value: ~$600,000
Employer uses: To help fund deferred comp payments
Employer: - No deduction: Cannot deduct COLI premiums - Deduct payments: Deduct deferred comp when paid to executive - Death benefit: Income tax-free to employer
Executive: - No current tax: Not taxed until receives payments - Ordinary income: Taxed when receives deferred comp payments - Forfeiture risk: If employer insolvent, may lose benefit
Life insurance instead of joint-survivor pension:
Pension payout options:
Single life annuity:
Retiree only: $4,000/month
At death: Payments stop
Spouse: Gets nothing
Joint and 50% survivor:
Retiree: $3,200/month (20% reduction)
After retiree dies: Spouse gets $1,600/month (50%)
Cost of survivor benefit:
Reduction: $800/month ($4,000 - $3,200)
Annual cost: $9,600/year
Lifetime cost: $9,600 × 20 years = $192,000
Pension max approach:
Example:
Choose: Single life at $4,000/month
Savings: $800/month vs. joint option
Use savings to buy:
Whole life insurance: $500,000
Premium: $800/month
If retiree dies:
Spouse receives: $500,000 (tax-free)
Invested at 4%: Generates $20,000/year ($1,667/month)
Compare to: $1,600/month joint option
Advantage: Slightly higher income + full principal ($500K)
Advantages: - Higher income: Get higher single life payment - Flexibility: Can adjust insurance as needs change - Lump sum: Spouse gets lump sum at death - Upside: If spouse dies first, keep higher pension
Risks: - Insurability: Must qualify for life insurance - Premium increases: If term insurance, premiums may rise - Policy management: Must maintain policy - Investment risk: Proceeds must be managed
Starting age 73:
Life insurance cash value: - In qualified plan: Subject to RMDs - Must distribute: Take cash or distribute policy - Taxable: Distributions taxable as ordinary income
Life insurance plays specialized roles in retirement planning, providing death benefit protection within certain qualified plans and serving as funding vehicles for non-qualified deferred compensation. Understanding the rules and restrictions is essential for proper planning.
ERISA-governed, tax-favored retirement plans:
Characteristics: - Tax-deductible contributions: Employer deducts contributions - Tax-deferred growth: Earnings not taxed until distributed - ERISA rules: Subject to Employee Retirement Income Security Act - Non-discrimination: Must cover broad employee base - Contribution limits: Annual IRS limits - Required distributions: RMDs starting age 73
Types: 1. Defined benefit plans (pensions) 2. Defined contribution plans (401(k), profit-sharing, money purchase) 3. 403(b) plans (tax-sheltered annuities for nonprofits) 4. 457 plans (deferred compensation for government/nonprofit)
Personal retirement savings: - Traditional IRA: Tax-deductible contributions, taxable distributions - Roth IRA: After-tax contributions, tax-free distributions - SEP-IRA: Simplified Employee Pension (employer contributions) - SIMPLE IRA: Savings Incentive Match Plan (small employer)
Not subject to ERISA: - Deferred compensation: Promise to pay in future - Executive benefits: Selective, for key employees - No current deduction: Employer deducts when paid - Flexible: Not bound by qualified plan rules
Life insurance is permitted in some qualified plans:
Allowed in: - ✓ Defined benefit plans (pensions) - ✓ Profit-sharing plans - ✓ 401(k) plans - ✓ Money purchase pension plans
Not allowed in: - ✗ IRAs (traditional or Roth) - ✗ SEP-IRAs - ✗ SIMPLE IRAs
Life insurance must be incidental to retirement savings:
Cannot be primary purpose: - Primary purpose: Retirement income - Life insurance: Incidental death benefit protection - Limits apply: Strict percentage limits
Limits on life insurance premiums in qualified plans:
50% Test:
Life insurance premiums ≤ 50% of total contributions
Example:
Total contributions to participant account: $100,000
Maximum for whole life premiums: $50,000 (50%)
Remaining for retirement investments: $50,000
25% Test:
Term insurance premiums ≤ 25% of total contributions
Example:
Total contributions: $100,000
Maximum for term premiums: $25,000 (25%)
Remaining for retirement: $75,000
Treated as whole life (50% test)
Example - Combined:
Annual contribution: $20,000
Whole life premium: $10,000 (exactly 50%)
Invested in mutual funds: $10,000
Total: $20,000
Meets 50% test: Yes
Alternative test for death benefits:
Death benefit cannot exceed:
Death Benefit ≤ 100 × Projected Monthly Retirement Benefit
Example:
Projected monthly retirement benefit: $3,000
Maximum death benefit: $3,000 × 100 = $300,000
If death benefit > $300,000: Violates rule
Annual taxable income to participant:
Imputed income: - Economic benefit: Value of pure insurance protection - Table 2001 rates: IRS table (formerly PS-58) - Taxable annually: Reported as income each year - Only term portion: Cost of pure protection, not cash value
Formula:
Annual Taxable Amount = (Death Benefit - Cash Value) × Table 2001 Rate
Example:
Participant: Age 45
Death benefit: $500,000
Cash value: $50,000
Table 2001 rate (age 45): $1.53 per $1,000
Net amount at risk: $500,000 - $50,000 = $450,000
Annual PS-58 cost: ($450,000 ÷ $1,000) × $1.53 = $688.50
Participant reports: $688.50 as taxable income (annually)
Pays income tax on: $688.50
Economic benefit doctrine: - Current benefit: Participant receiving death benefit protection now - Not deferred: Protection is current, not deferred to retirement - Must recognize: IRS requires annual income recognition
Options when participant retires or terminates:
Taxable amount formula:
Taxable = Cash Value - Cumulative PS-58 Costs Already Paid
Example:
Cash value at distribution: $80,000
Cumulative PS-58 costs paid over years: $15,000
Taxable income: $80,000 - $15,000 = $65,000
Participant pays tax on: $65,000
If participant dies before retirement:
Amounts paid to beneficiary: - Account value: Taxable as ordinary income (qualified plan distribution) - Life insurance proceeds: Income tax-free (IRC §101(a))
Example:
Death occurs:
Account value (investments): $200,000
Life insurance death benefit: $500,000
Total to beneficiary: $700,000
Tax treatment:
- Account value: $200,000 (taxable as ordinary income)
- Insurance proceeds: $500,000 (income tax-free)
Beneficiary owes tax on: $200,000 only
Receives tax-free: $500,000
IRC §408 - Life insurance not allowed:
Cannot hold in IRAs: - ✗ Traditional IRA - ✗ Roth IRA - ✗ SEP-IRA - ✗ SIMPLE IRA
Reason: IRAs designed exclusively for retirement savings, not life insurance
Permitted: - ✓ Annuity contracts (provide retirement income) - ✓ Stocks, bonds, mutual funds - ✓ Real estate (self-directed IRA)
Allowed: - Annuity contracts: Provide life-contingent income - Not life insurance: Focus on retirement income, not death benefit - Tax-deferred: Grow tax-deferred in IRA
Types: - Fixed annuities - Variable annuities - Indexed annuities - Immediate annuities (at retirement)
Permitted but uncommon:
Structure: - After-tax contributions: Typically funded with after-tax employee contributions - Separate account: Life insurance in separate sub-account - Participant choice: Optional, not mandatory - 50/25% test applies: Must meet premium limitations
Example:
401(k) participant:
Pre-tax deferrals: $15,000 (goes to mutual funds)
After-tax contributions: $10,000 (funds life insurance)
Whole life premium: $10,000
Total after-tax contributions: $10,000
Meets test: Yes ($10,000 is ≤ 50% of total contributions)
Pension plans funded entirely with insurance:
Characteristics: - 100% insurance/annuities: All assets in insurance contracts - Guaranteed benefits: Insurance company guarantees benefits - Level premiums: Fixed annual premiums - Predictable: No investment risk - Higher contributions: Typically higher than other pension plans
Used for: - Small business owners - Professional practices - Older owners (catch-up)
Example:
Small business: 3 partners, age 55
Want: Guaranteed pension benefits
Fund with: Life insurance and annuities
Annual contributions: $150,000
Guaranteed retirement benefit: $5,000/month at age 65
Death benefit: $1 million per partner
Informally funded:
Structure: - Employer promise: Agreement to pay benefits in future - Corporate-owned life insurance (COLI): Employer owns policy on executive - Employer = owner and beneficiary: Controls policy - Not plan asset: Executive has no rights to policy - Helps fund: Provides cash to meet future obligation
Example:
Executive age: 45
Deferred comp agreement: $100,000/year for 15 years at retirement
Present value: ~$800,000
Employer buys COLI:
Insured: Executive
Owner: Corporation
Beneficiary: Corporation
Face amount: $2 million
Premium: $30,000/year
At retirement:
Cash value: ~$600,000
Employer uses: To help fund deferred comp payments
Employer: - No deduction: Cannot deduct COLI premiums - Deduct payments: Deduct deferred comp when paid to executive - Death benefit: Income tax-free to employer
Executive: - No current tax: Not taxed until receives payments - Ordinary income: Taxed when receives deferred comp payments - Forfeiture risk: If employer insolvent, may lose benefit
Life insurance instead of joint-survivor pension:
Pension payout options:
Single life annuity:
Retiree only: $4,000/month
At death: Payments stop
Spouse: Gets nothing
Joint and 50% survivor:
Retiree: $3,200/month (20% reduction)
After retiree dies: Spouse gets $1,600/month (50%)
Cost of survivor benefit:
Reduction: $800/month ($4,000 - $3,200)
Annual cost: $9,600/year
Lifetime cost: $9,600 × 20 years = $192,000
Pension max approach:
Example:
Choose: Single life at $4,000/month
Savings: $800/month vs. joint option
Use savings to buy:
Whole life insurance: $500,000
Premium: $800/month
If retiree dies:
Spouse receives: $500,000 (tax-free)
Invested at 4%: Generates $20,000/year ($1,667/month)
Compare to: $1,600/month joint option
Advantage: Slightly higher income + full principal ($500K)
Advantages: - Higher income: Get higher single life payment - Flexibility: Can adjust insurance as needs change - Lump sum: Spouse gets lump sum at death - Upside: If spouse dies first, keep higher pension
Risks: - Insurability: Must qualify for life insurance - Premium increases: If term insurance, premiums may rise - Policy management: Must maintain policy - Investment risk: Proceeds must be managed
Starting age 73:
Life insurance cash value: - In qualified plan: Subject to RMDs - Must distribute: Take cash or distribute policy - Taxable: Distributions taxable as ordinary income