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Retirement Perspectives

If offered, a participant in a qualified retirement plan can purchase a life insurance policy inside their account. But there is a maze of rules about taxes and various exit strategies.

Many investors may not know that it’s possible to purchase life insurance within a defined benefit plan or defined contribution plan such as a 401(k) or profit sharing plan (not a 403(b) plan) to receive death benefits under the pan. However, plans that offer life insurance as an investment option tend to be complex to administer. An employer may offer life insurance inside a qualified retirement plan for a variety of reasons. For example, some participants may not be able to afford and/or qualify for insurance outside the plan, pretax dollars can be used to purchase insurance, and beneficiaries may receive potential tax-free death benefits.

There are a few reasons why an employer may not offer life insurance as an investment option, including: a policy can only be held in the plan while the employee is a participant in the plan; purchase of insurance reduces the amount available for retirement income; offering insurance adds to both the complexity and cost of administering a qualified plan; unwinding the insurance at the retirement of a participant or plan termination is complex; and the plan must abide the myriad of applicable ERISA rules and fiduciary issues can arise.

Can investors own life insurance in an individual retirement account (IRA)? No. Insurance is one of the few items, along with collectibles and S-Corporation stock, that cannot be held in an IRA. The prohibition on life insurance contracts includes whole life, universal, and term and variable policies. These investment restrictions hold true even in the case of a self-directed IRA (including SEP and SIMPLE IRAs). Therefore, qualified retirement plans, not IRAs, can hold life insurance.

A defined contribution plan such as 401(k) may purchase life insurance to provide death benefits under the plan. The premiums are charged against the plan participant’s account balance, while the insurance policy is an investment for the participant’s benefits. Notably, the purchase of separate life insurance contracts in a 403(b) is no longer permitted due to the final 403(b) regulations. However, the final 403(b) regulations do permit life insurance to be included in annuity contracts.

Generally, a distribution from a qualified plan (or IRA) subjects a participant or beneficiary to income tax when funds are actually distributed. There are exceptions to this rule. One exception is the ownership of a life insurance policy held inside a qualified plan. Policy premiums are paid with pretax dollars—however, the IRS will consider the pure cost of life insurance protection provided under the plan to be an “economic benefit” that is immediate taxable income to the insured. The cost of insurance protection that is taxable is calculated using IRS tables (known as P.S. 58 Table) that estimates the term cost of insurance at each age of the insured. Further, each year, Form 1099-R must be issued to the participant by the plan reporting the participant’s current benefit. The amount subject to income tax equals the cost of the insurance. This is characterized as a “deemed distribution” subject to income tax, but the income is not treated as a distribution. In other words, plan participants are subject to income tax each year on the part of the premiums attributed to the value of insurance.

Tip: IRC Section 72(t) generally imposes a 10% penalty tax on retirement plan distributions made to participants younger than age 59½. As covered above, when a qualified retirement plan purchases life insurance on behalf of a plan participant, IRS rules generally requires that the cost of the insurance be included currently in the participant’s income. This distribution is not subject to the 10% penalty.

Life insurance must be incidental to the primary purpose of a retirement plan, which is to provide retirement benefits to plan participants and beneficiaries. Therefore, the amount of life insurance that can be purchased inside a 401(k) is subject to certain limits. Generally, for a 401(k) plan, the total premiums must be less than 50% of the total employer contributions for whole life insurance and less than 25% for term or universal life insurance.  If a plan, by purchasing life insurance, exceeds these incidental limits, the plan may be disqualified because it has ceased to primarily be a retirement plan.  

Tip: Profit Sharing or Stock Bonus plans have more generous rules. If either of these plans purchases life insurance with “seasoned contributions,” the incidental life insurance limit that applies to 401(k) plans does not apply. Contributions are seasoned if they have been accumulated in the plan for at least two years.

Deeming life insurance an incidental benefit requires it to be converted into retirement income or distributed to the participant upon retirement. When an insured plan participant terminates employment or retires, he/she will have to make a decision about the insurance policy. Upon retirement, life insurance held in a qualified retirement plan cannot be rolled over to an IRA. However, it must be removed from the plan. What options are available to the insured? Surrender the policy, the plan distributes the policy, or the participant may purchase the policy from the plan. Importantly, the tax impact differs depending on the option chosen.

If a participant dies, their beneficiary will receive the life insurance benefit they have accrued in the employer plan, plus the life insurance death benefit. After death, the distribution of cash proceeds from life insurance inside the plan to the beneficiary may be taxable. While the life insurance portion of the policy is tax free, the cash surrender value minus the basis in the contract is taxable when it is withdrawn from the plan. 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.

If you have any questions about this or another retirement topic, please e-mail me at roadtoretirement@lordabbett.com.

 

To comply with Treasury Department regulations, we inform you that, unless otherwise expressly indicated, any tax information contained herein is not intended or written to be used, and cannot be used, for the purpose of (i) avoiding penalties that may be imposed under the Internal Revenue Code or any other applicable tax law, or (ii) promoting, marketing, or recommending to another party any transaction, arrangement, or other matter.

The information is being provided for general educational purposes only and is not intended to provide legal or tax advice. You should consult your own legal or tax advisor for guidance on regulatory compliance matters. Any examples provided are for informational purposes only and are not intended to be reflective of actual results and are not indicative of any particular client situation.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett's products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

GLOSSARY OF TERMS

Traditional IRA contributions plus earnings, interest, dividends, and capital gains may compound tax-deferred until you withdraw them as retirement income. Amounts withdrawn from traditional IRA plans are generally included as taxable income in the year received and may be subject to 10% federal tax penalties if withdrawn prior to age 59½, unless an exception applies.

A Roth IRA is a tax-deferred and potentially tax-free savings plan available to all working individuals and their spouses who meet the IRS income requirements. Distributions, including accumulated earnings, may be made tax-free if the account has been held at least five years and the individual is at least 59½, or if any of the IRS exceptions apply. Contributions to a Roth IRA are not tax deductible, but withdrawals during retirement are generally tax-free.

A SIMPLE IRA plan is an IRA-based plan that gives small-business employers a simplified method to make contributions toward their employees’ retirement and their own retirement. Under a SIMPLE IRA plan, employees may choose to make salary reduction contributions and the employer makes matching or nonelective contributions. All contributions are made directly to an individual retirement account (IRA) set up for each employee (a SIMPLE IRA). SIMPLE IRA plans are maintained on a calendar-year basis.

A simplified employee pension plan (SEP IRA) is a retirement plan specifically designed for self-employed people and small-business owners. When establishing a SEP IRA plan for your business, you and any eligible employees establish your own separate SEP IRA; employer contributions are then made into each eligible employee’s SEP IRA.

401(k) is a qualified plan established by employers to which eligible employees may make salary deferral (salary reduction) contributions on an aftertax and/or pretax basis. Employers offering a 401(k) plan may make matching or nonelective contributions to the plan on behalf of eligible employees and may also add a profit-sharing feature to the plan. Earnings accrue on a tax-deferred basis.

A 403(b) plan is a retirement savings plan that allows employees of public schools, nonprofit, and 501(c)(3) tax-exempt organizations to invest on a pretax and or Roth aftertax basis. Contributions to a 403(b) plan are conveniently deducted directly from your paycheck. In addition, your employer may elect to make a contribution on your behalf.

A governmental 457(b) deferred-compensation plan allows employees of states, political subdivisions of a state, or any agency or instrumentality of a state to invest money on a pretax or Roth aftertax basis through salary reductions. The employer deposits amounts withheld into an annuity, custodial, or a trust account, where the funds accumulate tax-deferred or potentially tax free in the case of Roth aftertax contributions until withdrawals commence, usually at retirement.

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