IRA Financial’s Adam Bergman welcomes Tim Messett, from Pension Investors Corporation of Orlando, to discuss investing in life insurance with your 401(k) plan and if it’s worth it.
We are please to be joined by Tim Messett, from Pension Investors, to discuss life insurance in a 401(k). As you may know, the IRS only tells us what we can’t invest in with our retirement funds. In fact, life insurance is on that list! However, there is an exception that can invest in life insurance with 401(k) funds. Of course, there are rules in place. Therefore, you must not run afoul of them with this, or any, investment choices.
Using Retirement Funds to Invest in Life Insurance
Along with most collectibles and transactions involving disqualified persons, life insurance cannot be invested with an IRA. The IRS site states, “Individual retirement accounts also are not permitted to invest in life insurance. (IRC Section 408(a)(3)).”
Therefore, if your only retirement account is an IRA, whether it is self-directed or not, you cannot invest in life insurance. On the other hand, if you have an employer-sponsored 401(k) plan, you may not have that option. Generally, 401(k) plans that you don’t control are limited in investment choices. Traditional assets, like stocks, bonds and mutual funds, may be your only option. Obviously, plans vary based on your employer, so life insurance investments may be allowed.
If you are self-employed, the power is in your hands. By setting up your own 401(k), known as a Solo 401(k), you are allowed to invest in just about anything you want. The caveat is you need the right plan administrator. IRA Financial administers thousands of Solo 401(k) plans, and if you choose, you can have checkbook control of your funds. This means you never have to ask permission to make an investments. In sum, the best plan to invest in life insurance is a checkbook control Solo 401(k).
Investing in Life Insurance with Your 401(k)
So long as your plan allows it (or you have a Solo 401(k) plan), you may invest in life insurance. However, there are several things you need to pay attention to.
First off, if you are investing through an employer’s plan, you must pay attention to how much your employer contributes on your behalf (assuming a match is offered). If you do receive a match, your insurance premiums cannot exceed 50% what your employer contributed for whole life insurance. If you invest in term life insurance, that amount drops to 25%. These are defined contribution plans.
If you have a defined benefit plan, the life insurance must be incidental. The death benefit cannot be greater than 100 times the expected monthly retirement benefit.
When you invest in life insurance with your traditional 401(k) plan, you use pre-tax money to pay the premiums. In order to stay IRS compliant, you must pay taxes on this money, known as basis in the contract. Essentially, the funds used to pay the premium is treated like a taxable distribution from the plan. Note, that even before you turn age 59 1/2, there is no early distribution penalty.
The amount is determined by subtracting the cash value from the death benefit of the policy. Obviously, this amount will be different each year.
Once you pass, the cash distributed from the policy may be taxable to your beneficiary. Ed Slott says “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.”
Options for When You Retire
There are three options for what to do with your life insurance when you reach retirement. Generally, when one retires, old 401(k) funds are rolled into an IRA. However, since an IRA cannot invest in life insurance, this is not a choice. In order to move funds into an IRA, you have to give up the policy to your insurance company. You will no longer have the insurance protection and your investment in the contract, however, you can take that money and move it to your IRA.
Another option is to buy the contract outright from your 401(k) plan. You must pay fair market value (FMV) for it, but it isn’t taxable. Lastly, you can distribute the policy from your 401(k). Of course, you will pay taxes as this is a taxable distribution. The amount is calculated by subtracting your total investment in the contract from cash value of it.
Should You Invest in Life Insurance
As with most investments, there are benefits and drawbacks of owning life insurance in a 401(k). Paying the premiums using pre-tax money is a great way to receive tax deductions. Your beneficiary would receive income tax-free death benefits when you pass. You can totally fund the retirement benefit at the premature death of policy holder. Further, since 401(k) plans allow for it, your assets are protected from creditors.
On the negative side is that you have to have access to a plan that allows for this investment. If you are not self-employed, you can only invest in life insurance if your employer allows it. Investing with 401(k) may be more complex (and therefore more expensive) than some people want. It might be easier to invest outside of the plan. Lastly, once you leave your job, getting the life insurance contract out of your 401(k) is not as straightforward as other, more traditional assets.
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Investing in life insurance is not for everyone. It will help diversify your portfolio, so you are not solely invested in traditional equities. However, if you are not careful, you could run afoul of the IRS.
Listen to the podcast to see what are guest, Tim Messett, and Mr. Bergman have to say about investing in life insurance in a 401(k). As always, thanks for listening and be sure to check out our SoundCloud page for more podcasts! If you have any question, please contact us @ 800.472.0646.