Can I buy life insurance in my 401(k)? - MarketWatch
Q.: Dear Dan,
We have a lot of money in our 401(k) that is tax deferred. We have been hearing pros and cons of IUL’s. Would that be somewhere that we could put some of our 401(k) money?
— Virginia
A.: Virginia, I’ll leave the relative merits of IULs, or indexed universal life insurance, for another time and just address the idea of buying life insurance in a 401(k) today. Theoretically, buying life insurance in a 401(k) can make it cheaper because pretax contributions are used to fund the premium payments but there are many complications. I can only briefly discuss a few of the basics in this space but you should get a sense from the description why most people see more cons than pros.
First, you cannot buy life insurance in a qualified plan like a 401(k) unless the plan explicitly allows it. Most plans do not allow the purchase of insurance. Your human resource office can provide you with a Summary Plan Description (SPD) which will state if life insurance is offered.
If allowed, even though the 401(k) itself is funded with pretax dollars, the ownership of insurance can cause taxable income from the plan to the employee. Each year, a 1099-R can be generated for the “cost of insurance.” I’ll leave an explanation of that term for another day too.
Policy types like Indexed Universal Life (IUL) are designed to be permanent insurance. These policies will accumulate a cash value that is used to help keep coverage in-force when the insured is older and the costs of insurance are higher and rising more rapidly than when the insured is younger.
This cash value presents another complication when a plan is terminated, you retire, leave for another job, quit, get fired, downsized, or otherwise leave the company. Once you cease to be a plan participant, the policy cannot stay in the plan and cannot move to an IRA. You either cash in the policy, transfer it out to a nonretirement account, or buy it from the plan. All these options have details you should discuss with your financial and tax advisers.
When cashed in, the cash surrender value remains in the plan and is treated the same as the other funds in the plans. However, the insurance coverage ends, terminating a product intended to be “permanent”. That may not be a problem if there is no longer a need for coverage, but most people in that situation find they would have paid less had they simply bought a term life insurance policy outside the plan.
When transferred to a nonretirement account, the policy remains intact, but the cash value is considered a distribution taxable as ordinary income, plus a 10% penalty if you are under 59 ½.
To buy the policy from the plan, no taxable event occurs, and the policy remains intact but you must have enough cash outside the plan to pay a “fair market value”.
If you have a question for Dan, please email him with “MarketWatch Q&A” on the subject line.
Dan Moisand’s comments are for informational purposes only and are not a substitute for personalized advice. Consult your adviser about what is best for you. Some questions are edited for brevity.
No comments