How a Profit Sharing Plan Works with Life Insurance

The Employee Retirement Income Security Act of 1974 (ERISA) contains two basic retirement structures: defined benefit plans and defined contribution plans. Profit sharing plans are defined contribution plans. An amended or a new profit sharing plan needs to allow life insurance as an option. For existing profit sharing plans, it can be as simple as checking the life insurance box.

Profit sharing plans that allow for life insurance premiums (contributions) are capped below 50% for whole life insurance and 25% for universal life insurance. But seasoned monies can be an exception to circumvent the incidental death benefit restrictions. Keep in mind, seasoned monies are funds greater than two years in the plan or the plan participant has been in the plan for five years or more. Other qualified plans like IRAs can also be rolled into a profit sharing plan as well. The other issue with a life insurance policy in a profit sharing plan is the economic benefit tax. It’s a relatively small annual tax on the death benefit portion of the life insurance policy.

Why would you want to purchase life insurance in a profit sharing plan? One reason is a heavily rated health classification. The contributions (or premiums) paid into a profit sharing plan are tax deductible. The tax savings could recover some of the impaired surcharge for the health condition. But the real retirement strategy here may be purchasing the life insurance from the profit sharing plan for the fair market value with non-qualified plan monies. One of the most popular cash value policies in profit sharing plans is indexed universal life (IUL). If the IUL is designed as a non-modified endowment contract, the purchased policy from the profit sharing plan can generate tax-free income. That tax-free income can be a combination of withdrawals of basis and collateralized policy loans of gain as long as the contract is kept in force for the life of the policy insured.

The remaining monies in the profit sharing plan can be systematically converted over to ROTH IRAs. You could borrow the necessary cash values in the indexed universal life policy to pay the conversion tax. By doing so, you can dramatically reduce or conceivably eliminate RMDs. It’s important to consult with a qualified plan and tax expert before moving forward with any part of this strategy.