Buying life insurance in a 401k:
Added: October 3, 2006
The 401k plan is basically a retirement plan to employees of the United States. With this plan, you get to save for your retirement, while avoiding income tax on the money that you save in the plan, and its interest. As the 401k plan is an employer sponsored plan for your retirement, it has to be set by the employer. In the plan, the employer and the employee decide on a certain percentage of money that has to be cut form their salary and deposited into the 401k account.
Some employers pay matching contributions to the employees’ to the 401k plan, while there are others who pay more than the employee’s contribution. They may in fact, increase the amount of contribution over the years. Once the employee leaves the job, most employers still keep the 401k plan active for the rest of the employee’s life. If this is not the preferred choice, the employee can either carry over the 401k plan to continue with the new employer, or perhaps, cash out all the money. However, on cashing out the money, there are some taxes and interest that has to be paid.
The main benefit with a 401k plan is that the employee has many options for the utilization of the money accumulated in the plan. The money can be used in mutual funds, stocks, money market funds and to buy life insurance too. The option of buying life insurance with the funds of the 401k plan is an option worth considering by small business owners and employees.
With the choice of buying life insurance as an investment choice in a 401k plan, the employee is offered lots of interesting advantages. One of the main advantages is that the premiums for the life insurance policy are made by payment of tax-deficit dollars. It is also possible to make premium payments through the income that is generated by some of the assets of the 401k plan.
This means that supposing you invest your 401k money in a bond fund. This bond fund in turn generates some income that is used to pay the premium of the life insurance policy that you buy. However, let it be known that the IRS considers this premium amount to be a taxable amount.
Now comes the question of who is permitted to buy life insurance in a 401k plan. It is the person who is older and wealthy, with the anticipation of having a need for permanent insurance that opts for buying life insurance in a 401k plan. This is because the permanent insurance here proves to be a great means for that person to cover any, and all anticipated estate tax liability.
In addition to this, the insurance policy also proves to be a great source of valuable death benefits where the participant can buy, or take by distribution on retirement for the needed permanent life insurance. While buying life insurance in a 401k plan, most of the costs that come associated with the purchase of a permanent life insurance policy are covered with tax-deferred dollars.
It is important that you choose the life insurance policy that you intend to buy through the 401k plan with great care. This is because the IRS has some limitations on the amount of contribution that can be made to the life insurance policy; be it a whole life or universal life insurance policy.
The contribution that is to be made to the life insurance premium is usually about 25 percent of the contribution that you make annually to your retirement, or 401k plan. This is if you intend to make premium payments directly from your 401k plan funds. However, if you intend to use some sort of plan resources like income that is generated through some investment of the 401k plan, then the premium payment proves to be tricky.
This is because the income that is generated from investments made through the 401k plan usually reduces the permitted contribution from regular income to the premiums. This is why it is usually advised to get some professional help and advice before actually considering to buy life insurance in a 401k plan. It is better to seek professional help even if it is only the employer or employee who is going to use the life insurance option. This is so that you will be sure that the insurance is sensible and that you understand all current and future implications of the life insurance policy.
Sometimes, buying of life insurance in a 401k plan is a great means of getting employees get insurance coverage as there are many people who don’t consider opting for buying life insurance if there is no tax deduction for premium payments. However, there is a small hitch to buying life insurance in a 401k plan. The participant of the plan has to declare the cost of the insurance coverage as a part of their gross income. However, this does not prove to be a point of worry as the amount that is taxable is minimum.
When one buys life insurance in a 401k plan, in the event of the participant dying prior to retirement, all the death proceeds that are found to be more than the cash surrender value is received by the dependants devoid of income tax. However, in case the participant retires with the life policy in hand, most 401k plans state that the life insurance policy is no longer attached in the plan. So in such cases, the policy has to be bought from the plan at its fair market value. These assets are treated like all the other assets of the plan, can is rolled over or distributed in a lump sum.
Another option is to surrender the contract where the plan receives the cash value as an asset of the plan. And the third option the participant can make is to have the plan distribute the policy as a partial lump distribution where you are taxed on fair market value of the life policy.
However, if you do change your 401k plan, the insurance policy may cause problems where you may have to buy the policy from the 401k plan. However, if the plan is terminated or if you leave your company, you will have to buy out or surrender the life insurance coverage. On the whole, buying a life insurance policy through a 401k plan is a great means of using tax-deferred dollars where its option lies in your hand.