I recently got a call from an employee who wanted to know if it made sense to use some of his retirement plan funds to purchase a life insurance policy.
My answer to him? “Let’s walk through the pros and cons.”
- The policy can be purchased using pre-tax dollars, freeing up their after-tax income for other financial goals.
- Employee can use up to 50 percent of plan’s yearly contribution to buy a whole life policy, or up to 25 percent of their yearly contribution to buy a universal or term life policy.
- The insurance coverage is fully portable in the event of termination or retirement.
- The coverage provides leverage for loved ones in case of premature death by providing a much higher death benefit than the actual plan funds may have accumulated to.
- Any cash value within the life insurance policy will be considered taxable income either at retirement to the employer or upon death to the beneficiary.
- The death benefit could be subject to estate tax, since a policy cannot be owned by an irrevocable life insurance trust within a retirement plan.
- The plan participant must declare a portion of the cost of the policy as taxable income based on an IRS Table – similar to the taxation of employer provided group term life, which defeats the purpose of using pre-tax dollars to begin with.
The other big question he needed to consider before buying life insurance through his retirement plan funds was whether he really needed any additional coverage based on his personal situation. Since he has a wife who doesn’t work, a good general rule of thumb is that he should have 10x his annual salary as a cushion for her.
I also recommended he run a life insurance needs analysis. After determining he needed an additional $250,000 to provide for his wife, he actually ended up buying a simple term life policy on his own, instead of dealing with the tax implications of using his retirement funds to buy the insurance.
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If your qualified retirement plan offers the option to purchase life insurance within the plan, these pros and cons should clearly be communicated to your employees, not just the standard disclaimer that they should seek the advice of their legal advisor.
This was originally published on the Financial Finesse blog for Workplace Financial Planning and Education.