How To Buy Life Insurance in a 401(k)

At Retirement

What happens if a participant retires with a life policy in the plan? According to Roll, most 401(k) plans require that the insurance no longer be held in the plan. He points out participants generally have three choices:

• Purchase the policy from the plan for its fair market value. The assets received by the plan would be treated like any of the other plan assets and could be rolled over or distributed in a lump sum or as an annuity.
• Surrender the contract. Again the plan would receive the cash value as a plan asset.
• Have the plan distribute the policy as a partial lump sum distribution and then you would be taxed on the fair market value of the life contract.

Life insurance cannot be owned in an IRA. This is why the policy cannot be rolled over into an IRA.

Investor Beware

All is not sweetness and light, however. Here are several things to keep in mind.

If you change 401(k) plans the insurance could be problematical. You might need to “buy it out” of the 401(k). This usually means cash up front.

If you terminate the plan (as a business decision) or leave the company you will probably have to buy out or surrender the life insurance coverage. As a business owner this is probably not much of an issue since you are in control of the 401(k) plan investment options and likely the only one choosing the life insurance option.

Lindsey Wilkins, Principal, global retirement operations and client reporting for Edward Jones, in St. Louis, cautions, “There aren't many plans that offer this [life insurance] as a typical investment option within the plan. In addition, your plan administrator must be willing to administer plans with life insurance in them. Sometimes there is an additional cost....so check.”

For the right people, however, owning life insurance inside a 401(k) can be a very effective use of tax-deferred dollars. It’s just not an option for everyone.