Some retirement accounts qualify for tax breaks, such as tax deductions and/or tax-free growth. The types of qualified accounts include defined-benefit employer plans, defined-contribution employer plans and individual retirement accounts. The Internal Revenue Service doesn't permit you to use IRA money to buy life insurance, but you can own life insurance in a qualified employer plan.
Qualified Employer Plans
Qualified employer plans must conform to the rules of the Employee Retirement Income Security Act of 1974, or ERISA. For example, qualified plans must meet requirements for participation, vesting, reporting, disclosure, funding and administration. Qualified employer plans can provide “incidental” life insurance benefits, meaning that the amount of insurance is subject to restrictions. Other rules affect the taxes on the employee and on the insurance beneficiary after the employee’s death. IRA-based employer plans, such as SIMPLE and SEP IRAs, cannot own life insurance.
A defined-contribution plan provides benefits that depend on how much money is contributed and how it’s invested. The IRS limits the amount employers and employees can contribute each year. A defined-contribution account can allocate no more than 50 percent of contributions to whole life insurance. The limit drops to 25 percent for term or universal life policies. If your account has a mix of whole life and other insurance policies, the 25 percent limit applies to the sum of the other life insurance premiums plus half of the whole life premiums. At retirement, the employee must cash in, sell or distribute the plan's life insurance contracts.
A special rule applies to the profit-sharing type of defined contribution plans, such as 401(k)s. These plans may restrict the amount used to purchase life insurance to “seasoned money” -- that is, money that has accumulated in the account for a fixed number of years. Different plans have different seasoning periods, but the minimum period is two years. Alternatively, all money becomes seasoned once the employee owns the profit-sharing account for five years. If the plan allows only seasoned money to pay the insurance premiums, the percentage limits for defined-contribution plans don’t apply. However, the percentages do apply if you can buy the insurance using a mix of current and seasoned money.
Defined benefits plans specify how much the employee will receive in retirement. These plans have four alternative rules to specify how much money can pay for life insurance premiums. The first set of rules matches those applying to defined-contribution plans. The second rule is the “100-to-1 test,” which requires the death benefit not to exceed 100 times the anticipated retirement benefit. The cost of this death benefit can’t exceed 25 percent of the cost of all benefits. The third rule is the “one-third test,” which requires the employer to figure the annual contribution amount assuming no life insurance and set one-third of the amount as available for life insurance. If whole life insurance is purchased, the fraction becomes two-thirds. The last method applies to fully insured defined-benefit plans, in which all contributions can be spent on life insurance.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.