How To Buy Life Insurance in a 401(k)
The Inner Workings
Choose your 401(k) plan life insurance options with care. The IRS places limits on the amount of your contribution you can allocate to life insurance, whether whole life (WL) or universal life (UL). Contributions to life insurance premiums are generally limited to 25 percent of the owner’s annual retirement-plan contributions. If a participant uses plan resources (such as income from plan investments) to pay premiums it can get tricky; income from other investments will likely reduce the allowable contributions from regular income to the premiums, for example. As Roll cautions, it is essential to get all your professional advisors involved before offering life insurance as a plan option.
Even if the employer/owner is the only one using the life insurance option (sometimes employees may elect this choice, too), it is advisable to consult with your attorney and CPA to make sure the insurance makes sense and you understand the current and future tax implications. Providing a life-insurance option using pre-tax dollars and/or 401(k) earnings might, in fact, be a nice way to convince employers to get coverage, says Righthand: “Some people will never buy life insurance for their loved ones if they can't get a tax deduction for paying the premium!”
There is a very small immediate tax implication: The 401(k) plan participant must declare the "cost" of the insurance coverage in gross income (using Table 2001 rates or one-year term rates from the insurance company). According to Roll, the taxable amount is, “very small…essentially like the group term cost an employee gets on his/her W-2.” Also, if the participant dies prior to retirement, death proceeds in excess of cash surrender values are received free of income taxes, according to the IRS Tax Facts/2006 Field Guide.
