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How Can the Solo 401k Invest in Life Insurance?

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Investors often wonder if they can use Solo 401k funds to buy life insurance. For many, life insurance is a fundamental part of a secure personal financial structure. Life insurance is about much more than simply placing a monetary value on your life (or your spouse’s life). It helps those who remain behind to pay final expenses. Additionally, life insurance can lessen future financial uncertainties for survivors. It’s not just for your peace of mind; it’s also for their peace of mind.

Even if you have significant financial and retirement assets, life insurance helps your survivors maintain financial stability after your passing. This can alleviate financial burdens for your survivors, such as mortgages, loss of income, college expenses, etc.

But from the beginning, one thing that you need to know is that you can’t purchase a life insurance policy through a traditional IRA. Even a self-direct IRA. You can purchase it outside of a retirement plan. But life insurance premiums aren’t generally tax deductible. Therefore, consider the advantages of purchasing a life insurance policy through your Solo 401k retirement account with partially tax-deferred money.

You Could Have Life Insurance Through Your Employer’s 401k

Your employer 401k plan is allowed to buy life insurance. But most don’t. When you open a Solo 401k for your own business, you can also provide life insurance for yourself as an employee of your business.

There are several reasons that outside employers don’t offer life insurance plans. Among the reasons is that the policy can only be held while the employee is a participant in the plan. This is not an issue with a Solo 401k. That’s  because when you own your own business, you are considered an owner-employee. Therefore, you will remain a participant in you own small business retirement plan.

Offering insurance to large groups of employees also adds to the complexity of administering the plan. This problem is also minimized with a Solo 401k because you and your spouse are the only plan participants.  If you have business partners (no full time employees), we can still set up a Solo 401k for you and your spouse. Outside employers also fear the burden of fiduciary responsibilities that you don’t have as the owner of a Solo 401k.

The bottom line is that it can make good financial sense to hold a life insurance policy in your Solo 401k.

The Four Roles in a Solo 401k Life Insurance Plan

To understand the structure of holding life insurance in a Solo 401k, first understand the four primary roles involved with a life insurance policy.

  1. The insurer (the insurance company responsible for paying claims after death of the insured).
  2. The policyholder or policy owner (the Solo 401k that is responsible for paying premiums).
  3. The insured (the person whose life the policy is based on and which the policy will pay claims against).
  4. The beneficiary (the person(s), trust, or other entity to receive the payments upon death of the insured).

For a policy held outside of a Solo 401k, the policy owner and the insured are often the same person. For instance, the main breadwinner in a household is often both the insured and the policy owner. The policy owner pays the premiums. This keeps the remainder of the household financially protected if the breadwinner dies. The difference with a Solo 401k owned policy is that the Solo 401k pays the premiums. This insures the life of the owner of the Solo 401k (you).

How To Pay Your Premiums

Life insurance policy is both an investment for the future and also has immediate benefits. The future investment (after retirement) is part of what qualifies a Solo 401k to own a life insurance policy. The immediate benefit is the fact that the policy could pay benefits before retirement if the insured (you) passes away. The future and immediate benefits complicates how the IRS treats the premium payments that the Solo 401k pays. The premiums are paid by the plan, but the insurance policy is an investment for the participant’s benefit.

The policy premiums are paid with pre-tax dollars from the Solo 401k. But there will be tax consequences. That’s because the IRS considers the cost of life insurance protection provided under the plan to be an “economic benefit”. Therefore, is is immediate (not after retirement) taxable income to the insured. The taxable cost of the life insurance is calculated using IRS tables that are commonly known as the P.S. 58 Table. (Also see; Split-dollar life insurance arrangements).

Reporting Requirements

Each year, the Solo 401k must issue a Form 1099-R stating the participant’s current benefit. This is the “deemed distribution” subject to income tax, but the income is NOT treated as a distribution. You’ll personally pay income tax on that value. However, you won’t pay the 10% penalty tax on retirement plan distributions made to participants younger than age 59½. Furthermore, you won’t pay income tax on the full premium because of the future investment value. This is where the split dollar arrangement comes in.

There are limits to the amount of insurance that the Solo 401k can purchase. This is because the life insurance cannot be the primary purpose of the Solo 401k. Generally, the total premiums must be less than 50% of the total employer contributions for whole life insurance and less than 25% for term or universal life insurance.

Options for Distributing the Life Insurance Benefits from a Solo 401k

You must have an active business to retain an active 401k plan. When you retire from your business, the Solo 401k shuts down as well. That means you will need to distribute the assets/funds, including the life insurance policy. One option is having the policy distributed to you. Generally, you’ll have to pay taxes (at your retired tax rate) on the cash value of the policy minus your total investment in the contract. It becomes part of your retirement income.

Another option is selling (surrendering) the policy to the insurance company for the cash value. You’ll lose the full death value of the policy but the cash will go into your Solo 401k for further investing and/or distribution as retirement income.

A third option is to purchase the policy from your Solo 401k for the fair market value. This won’t cost you anything in taxes. However, you will have to come up with the money to buy it out of the Solo 401k.

Certainly, there are other possibilities and options that you’ll want to talk over with your tax advisor. But the fact is that you can purchase a life insurance policy with your Solo 401k. If you are serious about growing your retirement account to the maximum, you need to take full control of your financial future.

Have questions about growing your retirement account? The 401k experts at Nabers Group will help you get your retirement funds into your control, where they belong.

4 Responses

  1. I donot understand why SD IRA does not allow to invest life insurance and Solo K does? And tax issue make life insurance unfavorable if using Solo K buy life insurance. I would learn more on this point

    1. Thanks for your message, Dewayne. IRAs and 401ks are governed by different sections of the tax code. IRAs come from Internal Revenue Code Section 408 while 401k plans come from Internal Revenue Code Section 401. A Solo 401k is a qualified retirement plan, and thus has the ability to invest in life insurance while an Individual Retirement Arrangement (IRA) does not.

  2. Can you leverage the cash value in the policy owned by the 401k, and use those funds outside of the policy with no tax/penalty implications. Example, can i borrow 10k in cash value from the solo 401k owned life insurance policy and buy a personal vehicle? Then make payments back to the policy, similar to taking a 401k policy loan?

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