Many retirement investors might not immediately think of buying life insurance for a 401(k), it can be a viable option.
Buying life insurance for such a retirement account can make it less expense since pre-tax contributions are used to fund premium payments. However, there are certain complications. But aren’t there always?
First, the 401(k) plan has to specifically allow the purchase of insurance within the plan. There is also the chance that ownership of insurance could cause taxable income from the plan to the employee. Savers could end up with a 1099-R “cost of insurance” document to deal with every year.
Indexed universal life (IUL) plans are designed to be permanent insurance. They accumulate a cash value that helps to keep coverage in force when the insured person is older and the costs of insurance will be higher. The cash value can also create complications when plans are terminated, the saver retires, or leaves the company. Once the saver ceases to be a plan participant, the policy can’t stay in the plan, nor can it be moved to an IRA. The holder will have to cash in the policy, transfer it to a nonretirement account, or actually buy it from the plan. All have consequences that should be discussed with financial and tax advisors.
When a policy is cashed in, the surrender value stays in the plan and is treated the same as other investments in the plan. The insurance coverage will end though. If there is no longer a need for coverage, that is not a problem but most savers will find that they would have spent less by purchasing a term life insurance policy outside the plan.
If a client chooses to transfer the policy to a nonretirement account, the policy remains in force but the cash value is deemed a distribution and is taxed as ordinary income. If the owner is under 59 ½, there’s also a 10% penalty. Those who want to buy the policy from the plan can avoid a taxable event, but will have to pay a fair market value.
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Opinion: Can I buy life insurance in my 401(k)? | MarketWatch