The attraction of using your 401(k) to pay for life insurance stems from the partially tax-deductible premiums. Qualified defined contribution plans such as a 401(k) provide for tax-deductible contributions by employees and employers. The Employee Retirement Income Security Act places some limits on the amount of life insurance you can buy with 401(k) money, but the limits fall away after a few years.
401(k) Life Insurance Limits
You can buy 401(k) life insurance only if your employer’s plan permits it. You might be able to purchase group life insurance through your employer or buy an individual policy if your employer allows it. Initially, half of your 401(k) premiums can pay for whole life insurance premiums. Only a quarter of your premiums can buy term or variable universal life insurance. However, after you’ve participated in the plan for five years, you can use all of your account balance to buy life insurance. Furthermore, all assets that have been in the plan for three years and all rollovers can buy life insurance. The rules permit you to roll over other pension plans and individual retirement accounts into your 401(k) tax-free.
Part of the premium you pay for 401(k) life insurance is current taxable income. The Internal Revenue Service considers the one-year cost of term insurance to be the current taxable benefit of a 401(k) life insurance policy. You must include in your taxable income the annual premium on a term life insurance policy offered by the insurer of your 401(k) policy. Any death benefit in excess of the policy’s cash value is tax-free to beneficiaries, and the cash value portion of the death benefit can be rolled tax-free into an IRA.
You can name others, including your spouse, other relatives or a business partner, as the insured party on your 401(k) life insurance policy. When you retire, you can choose to surrender a non-term policy for its cash value, annuitize the cash value into a period-certain or lifetime annuity or take the policy as a distribution from the plan. Term life insurance policies don’t have a cash value. If you convert the policy to an annuity, any payouts in excess of the cost basis are taxable. The cost basis is the amount of taxable premiums you pay into the policy.
The limits on 401(k) contributions might restrict how much life insurance you can buy in the plan. As of 2014, you can contribute up to $17,500 a year of your pre-tax compensation to a 401(k). If you’re age 50 or older, you can contribute an additional $5,500 per year. Your employer can kick in additional contributions to bring the annual total to $52,000, or $57,500 for employees age 50 or older.
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