Buying Life Insurance in Employer Retirement Plans
You are allowed to buy life insurance inside your employer retirement plan, such as a 401(k) or profit sharing plan. While many plans don't offer life insurance as an investment, some in fact do.
There are limits on how much you can buy based on the amount of contributions made to your plan on your behalf. In a 401(k) or profit sharing plan, the general rule is that the total premiums must be less than 50% of the total employer contributions to the plan for whole life insurance. For term life insurance, the total premiums must be less than 25%.
You have to pay income tax each year on the part of the premiums attributed to the value of the pure life insurance protection. This amount you pay taxes on each year is known as your “basis in the contract.” It’s also considered a deemed distribution from the plan that’s taxable to you, but there’s no 10% early distribution penalty if you are under age 59 ½.
After you die, distribution of cash proceeds from life insurance inside the plan to your beneficiary may be taxable. While the life insurance portion of the policy is tax-free, the cash surrender value minus your basis in the contract is taxable when it is withdrawn from the plan.
But when you retire, know that the life insurance policy can’t be put into your IRA. Life insurance in an employer plan cannot be rolled over to an IRA because the tax code says it’s a prohibited investment inside an IRA.
Generally, when you retire, you will have three choices on what to do with that insurance policy. Option 1 is to have the plan distribute the policy to you. You will pay taxes on the fair market value of the policy (generally the cash value of the policy minus your total investment in the contract).
Option 2 is to surrender the policy to the insurance company for cash. You will lose the life insurance protection and your investment in the contract, but the cash proceeds can be rolled over to your IRA.
Option 3 is to buy the policy from the plan at its fair market value. While this purchase isn’t taxable to you, nonetheless you have to come up with the money buy it.
- By Joe Cicchinelli and Jared Trexler
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