Retirement Funds For Life Insurance: A Smart Move?

Life insurance is a commonly used tool to protect against potential income and other losses. It can be purchased through some qualified retirement plans, like a 401(k) or a pension, and can provide death benefits. However, there are strict rules and potential disadvantages to this strategy, and it may not be suitable for everyone. This paragraph will explore the topic of purchasing life insurance using qualified retirement money and discuss the advantages and disadvantages of this approach.

Using pre-tax dollars to pay for life insurance

Life insurance can be purchased using pre-tax dollars in certain circumstances. Pre-tax dollars can be used to pay for life insurance when it is offered as a group-term life insurance benefit to employees, with employees purchasing some or all of their coverage with pre-tax salary reduction contributions through a cafeteria plan. This type of plan allows employees to exclude from their gross income the cost of up to $50,000 in employer-provided group-term life insurance coverage. If employees purchase more than $50,000 of coverage with pre-tax contributions, the pre-tax premiums remain tax-free, but the value of the coverage in excess of $50,000 becomes subject to federal income and FICA taxes.

Additionally, life insurance can be purchased with pre-tax dollars through some qualified retirement plans, such as a 401(k) or a pension. These plans can be complex to administer and must follow strict rules for managing the life insurance policy. The life insurance policy can only be held in the plan while the insured is a participant, and it can be challenging to separate the insurance if the insured retires or the plan is terminated. Furthermore, the organisation sponsoring the plan must offer a qualified plan that permits life insurance, and these plans tend to be costly and complicated to set up.

In a defined-contribution plan, if a whole life policy is purchased, the premium must be less than 50% of the contributions made to the plan. For term or universal life policies, the premium must be less than 25% of the total contributions. Defined-benefit plans have different requirements, with rules such as the "100-to-1 test," which mandates that the death benefit must not exceed 100 times the anticipated retirement benefit, and the "one-third test," which requires the employer to set one-third of the annual contribution amount as available for life insurance.

It is important to note that while using pre-tax dollars to pay for life insurance can offer tax advantages, there are also potential disadvantages and complexities associated with these options. It is always recommended to consult with a financial professional before making any decisions regarding life insurance or retirement plans.

Pros and cons of buying life insurance with retirement money

Pros

• Life insurance can be purchased through some qualified retirement plans, like a 401(k) or a pension.
• You can pay for the coverage using pre-tax dollars, which means you save on taxes while buying life insurance.
• It can help you leave an inheritance and pay estate taxes.
• It can help cover final expenses and pay off debt.
• It can provide financial security for loved ones in case of your death.
• It can be the only way some employees can afford insurance.
• It can be available on a guaranteed-issue basis even for those who would be uninsurable on the open market.
• It can help protect your family in the event of premature death.
• It can be used to make a charitable contribution.

Cons

• Life insurance policies can only be held in the plan while you are a participant.
• Unwinding the insurance at retirement or if the plan is terminated can be complex.
• The business needs to have a qualified plan that allows for life insurance, and these plans tend to be costly and complicated.
• Plans must abide by ERISA rules that require all eligible employees to be included.
• The rate of return on a life insurance policy may be lower than that of alternative investments, so having insurance in the plan may reduce the participant's overall retirement benefit.
• P.S. 58 costs are taxable each year, causing an additional burden on the plan sponsor to properly report and track.
• Permanent life insurance can be expensive, especially for retirees.

Types of life insurance that can be purchased with retirement money

It is possible to buy life insurance through some qualified retirement plans, such as a 401(k) or a pension. However, not all retirement plans allow for the purchase of life insurance, and there are strict rules that must be followed. Here are some types of life insurance that can be purchased with retirement money:

Term Life Insurance

Term life insurance is temporary coverage that lasts for a set period, typically 10 to 30 years. If you outlive the term or stop paying premiums, the coverage ends. Term life insurance is generally more affordable than permanent life insurance, but it does not build cash value.

Whole Life Insurance

Whole life insurance is a type of permanent life insurance that does not expire as long as premiums are paid. It often includes a cash value component that policyholders can access during their lifetime. Whole life insurance is commonly used in estate planning and can be useful for lifelong needs.

Universal Life Insurance

Universal life insurance is another type of permanent life insurance that offers flexibility in premium payments. Unlike whole life insurance, which usually has fixed premiums, universal life insurance allows for adjustments in premium payments over time. It also includes a cash value component that earns interest.

Burial Insurance

Also known as final expense or funeral insurance, burial insurance is a small whole life insurance policy designed to cover funeral and burial costs. These policies typically offer coverage ranging from $5,000 to $35,000, and some do not require a medical exam.

It is important to note that while life insurance can be purchased through certain qualified retirement plans, there are complexities and regulations that must be considered. Additionally, individual policies may be easier to manage and provide more flexibility in designing coverage. Consulting with a financial expert or advisor is recommended to determine the best course of action for your specific situation.

How to buy life insurance with retirement money

It is possible to buy life insurance through some qualified retirement plans, such as a 401(k) or a pension. This allows you to pay the premiums with pre-tax dollars and your existing retirement funds. However, there are strict rules and limitations, and it can be a complex and expensive process.

Qualified employer plans

Qualified employer plans must conform to the rules of the Employee Retirement Income Security Act of 1974 (ERISA). These plans can provide "incidental" life insurance benefits, meaning that the amount of insurance is subject to restrictions. There are also rules regarding taxes on the employee and the insurance beneficiary after the employee's death.

Defined-contribution plans

A defined-contribution plan provides benefits based on the amount of money contributed and how it's invested. The IRS limits the amount that employers and employees can contribute each year, and there are restrictions on how much can be allocated to life insurance. A defined-contribution account can allocate no more than 50% of contributions to whole life insurance, and the limit drops to 25% for term or universal life policies.

Defined-benefit plans

Defined-benefit plans specify how much the employee will receive in retirement. These plans have four alternative rules to specify how much money can be used to pay for life insurance premiums. The first set of rules matches those for defined-contribution plans. The second rule is the "100-to-1 test," which requires the death benefit to not exceed 100 times the anticipated retirement benefit. The third rule is the "one-third test," which requires the employer to set one-third of the annual contribution amount as available for life insurance. The last method applies to fully insured defined-benefit plans, where all contributions can be spent on life insurance.

Steps to buying life insurance with retirement money

• Check with your employer or retirement plan provider to see if the plan allows for life insurance as an option.
• Determine the type and amount of insurance coverage you need, such as term or permanent life insurance.
• Choose a life insurance provider that can offer coverage that fits your needs.
• Fill out the required paperwork to enroll in the life insurance coverage.
• Pay the premiums for the life insurance coverage through your retirement plan contributions. Remember that this will reduce the amount you contribute to your retirement plan, so you may need to adjust your contribution amount.
• Review your retirement plan and life insurance coverage periodically to ensure they continue to meet your needs.

Advantages and disadvantages

Buying life insurance with retirement money can offer several advantages, including:

• The ability to use pre-tax dollars to pay premiums, which can provide tax benefits.
• The option to pay for insurance using existing retirement plan savings.
• Providing an income-tax-free death benefit to your policy beneficiaries.
• Asset protection, as ERISA plans are generally protected from creditors.

However, there are also some disadvantages to consider:

• The life insurance policy can only be held in the plan while you are a participant.
• It can be complex and costly to set up and administer, especially when compared to an individual policy.
• Unwinding the insurance when you retire or if the plan is terminated can be complex.
• The plan must follow strict rules, including ERISA rules that require all eligible employees to be included and prohibit discrimination in favor of certain participants.

Alternative options

Before proceeding, it is essential to consult with an insurance and retirement plan expert to determine the best option for your specific situation. In many cases, purchasing an individual policy may be a more straightforward and flexible solution. Additionally, consider the following alternatives:

• Create an emergency fund: Build a savings fund equal to three to six months' worth of living expenses to cover any unexpected bills.
• Invest in disability insurance: Consider long-term disability insurance to replace lost income if you are unable to work.
• Invest in a retirement account: Invest any disposable income in a tax-advantaged retirement account, such as a traditional or Roth IRA, or maximize contributions to your 401(k) plan.

Final thoughts

While it is possible to buy life insurance with retirement money, it is important to carefully consider the advantages and disadvantages of this option. Consult with financial and tax advisors to ensure that you make the most suitable decision for your specific circumstances.

Life insurance as a retirement plan

Life insurance can be purchased using qualified retirement money. Qualified employer plans can own life insurance policies, but they must conform to the rules of the Employee Retirement Income Security Act of 1974 (ERISA). For example, qualified plans must meet requirements for participation, vesting, reporting, disclosure, funding, and administration.

Life insurance is often referred to as a retirement plan due to the cash component of some life insurance policies, which can act as retirement income for individuals. However, life insurance should not be considered a replacement for other traditional retirement plans, such as 401(k)s and IRAs. The rate of return is generally not as high as investing in the stock market.

Life insurance retirement plans (LIRPs) are permanent life insurance policies that use the cash value that accumulates over time to help fund your retirement. The cash value can be withdrawn or borrowed against to provide tax-free income in retirement years. However, LIRPs are expensive to maintain and are therefore usually only beneficial for high-net-worth individuals.

For most people, the best way to incorporate life insurance into retirement planning is to buy a simple term life policy with an adequate death benefit and invest any other disposable income in tax-advantaged retirement accounts. Term life insurance is much less expensive than permanent life insurance and provides basic financial protection for a family if one of the breadwinners dies prematurely. The lower premiums free up more disposable income to invest for retirement or other financial goals.

• Buy Term Insurance: Except for the independently wealthy, anyone with dependents should have life insurance. A term life policy will provide the most value for your money.
• Create an Emergency Fund: Put the savings from the low-cost term life insurance into an emergency fund equal to three to six months of living expenses.
• Disability Insurance: Consider long-term disability insurance to replace lost income if you are unable to work.
• Invest the Rest: Invest any remaining disposable income in a tax-advantaged retirement account, such as a traditional or Roth IRA, or a 401(k) if you have access to one.

Frequently asked questions