Life insurance in qualified plans.

• Author: Henderson, Tracie K.

In addition to retirement benefits, pension and profit-sharing plans may provide life insurance coverage. Here is a brief explanation of the applicable rules, and who might want to take advantage of them.

Incidental death benefits

Pension and profit-sharing plans may provide for the payment of "incidental" death benefits (Regs. Sec. 1.401-1(b)(1)). Depending on the type of plan, the maximum amount of plan funds that can be used to purchase insurance ranges from 25% to 100%. (See Rev. Ruls. 61-164, 60-84, 60-83, 61-121, 68-31, 68-453 and 74-307.)

Tax treatment of life insurance coverage

The cost of life insurance coverage purchased by a qualified plan must be included in the employee's gross income if the proceeds are payable to the employee or a beneficiary of the employee (Regs. Sec. 1.72-16(b)). For this purpose, "cost" is not the premium payment; instead, cost is calculated using the P.S. 58 rates, which generally will be less than the actual premium (Rev. Rul. 55-747). If the insurer's rates for original issue one-year term insurance protection available to all standard risks are lower than the P.S. 58 rates (usually the case), those rates can be used instead (Rev. Ruls. 66-110 and 67-154).

Although the purchase of life insurance coverage appears to be a plan distribution, since it provides the plan participant with a current taxable benefit, the cost of coverage included in an employee's income is not considered a distribution for purposes of the 10% premature distributions tax (IRS Notice 89-25).

Tax treatment of life insurance proceeds

Life insurance proceeds in excess of a policy's cash surrender value are excluded from income under Sec. 101(a) (Sec. 72(m)(3)(C); Regs. Sec. 1.72-16(c)(2)(ii)). The cash surrender value (in excess of the investment in the contract) immediately before the insured's death is treated as a plan distribution includible in income except to the extent exempted under Sec. 101(b) (Sec. 72(m)(3)(C); Regs. Sec. 1.72-16(c)(2)(iii)).

Caution: Even though the regulations allow plans to provide insurance coverage for a participant's family members, the purchase of a cash value policy on a family member's life could result in a premature distribution if the family member dies before the participant reaches age 59 1/2. Choosing a second-to-die policy on the lives of the participant and a family member would avoid this potential problem.

The amount of policy proceeds in excess of the cash surrender value immediately...