Life Insurance In The 401(k)
Life Insurance - Who Needs It?
We often hear the charge that life insurance has been unnecessarily purchased. We could ask ourselves who would suffer financially from our death. If there are those who would, then life insurance is indeed necessary.
When the answer is yes, life insurance can provide great "peace of mind," as they say. As wealth is built within the 401(k), the need for life insurance may diminish. Life insurance should be purchased to protect the income of the spouses involved and to ensure that the dreams of the family are financially able to come true. Does the family want to send their children to school? Could they do so if one of the working spouses suddenly died? Would the family lose their home if one of the spouses died? Does one of the spouses care for a disabled child or grandparent? Is the estate worth enough that estate taxes would hurt the living spouse?
Each question will have different answers for different people. Most people would not have an estate worth $1.2 million dollars and have to worry about estate taxes. A family could have an investment portfolio that pares down the need for life insurance coverage.
The main question is always "If I were to die, would my loved ones suffer financially?"
Purchase Life Insurance Within A 401(k)?
"Wrapping up insurance inside a 401(k) plan makes little sense, especially when the expense charges are considerably more than similar investments."
"If you need life insurance, buy pure life insurance coverage (insurance that is only insurance and builds no cash value). Buy term life insurance outside your 401(k), and invest inside your 401(k)."
The Complete Idiot's Guide to 401(k) Plans
By Wayne G. Bogosian and Dee Lee
Some investment advisors say that life insurance within a 401(k) has its place if used correctly. We will go over some advantages, but first the negatives.
Negative - Misuse
Life insurance is seldom an investment. A person's 401(k) plan is an investment. Life insurance policies that offer an investment component, like variable life, are already tax sheltered. So if the 401(k) participant is purchasing life insurance as an investment it does not make sense since the expense charges are so high. If the 401(k) participant is purchasing life insurance for the coverage, they could find the same coverage cheaper outside the 401(k).
It is true that financial protection of the family should be a first step (prior to using the 401(k) plan). Once adequate family protection is in place, however, the 401(k) plan should be utilized.
As the 401(k) plan grows, the family may be able to reduce their life insurance needs and save on premiums. Dismissing an established life insurance plan should never be done without thought, even if the 401(k) plan is doing well. Since the 401(k) is a retirement plan, life insurance may still be a wise choice for family protection.
Negative - Non-Competitive Product Choices
As with everything, the participant will want to look at what other companies are charging for the same coverage. Selecting a sound insurance is a wise choice, but comparison-shopping to find out how much will be paid per $1,000 unit of coverage must be a consideration.
Cash-Value insurance comes in two parts:
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The insurance policy, and
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The savings or investment account.
The participant will pay a larger premium for cash-value insurance than they would for term life coverage. The "extra" money goes into an account where it builds up tax-deferred.
The premium dollars that go into the investment side (cash value side) of the account will grow at a guaranteed or expected rate of return. Comparing these guaranteed rates of return from one insurer to the next is not difficult. Comparison-shopping may even enable the participant to reduce or eliminate some negative aspects of purchasing life insurance. Every field agent has probably done some comparison-shopping. Their knowledge can be very valuable for the consumer.
According to Making the Most of Your Money by Jane Bryant Quinn, a person should consider investing in cash-value insurance if a person has used up all the tax-deductible, tax-deferred savings available to them. Company 401(k) plans, pension annuities, deferred compensation, and deductible IRAs may be better deals than cash-value insurance. If an IRA is not tax deductible, however, insurance might be better.
The operative word is "used up." Since it has already been stated that Americans are poor savers, relatively few people will "use up" all of their tax-deductible, tax-deferred investment choices. The majority of people will still have those choices available to them.
Many professional investment advisors feel it is best to purchase term insurance, as long as the savings in insurance premiums are invested. When 401(k) plans are available, they are an excellent investment choice. So, too, are tax-deductible IRAs.
Negative - Costs too Much
Some companies charge more than others to install or set up a plan. Some insurance contracts include penalties or provisions that may wipe all or part of any cash build up in the early years of the policy. Some insurance companies price their products in such a way that, while they provide inexpensive life insurance, the investment side of the product is loaded with excessive fees. Some insurance companies may offer products that are financially more appealing to younger members that older ones. All of these factors lend to the cost of the product and all of these factors must be considered.
Are There Advantages To Life Insurance Within a 401(k)?
Are there any advantages to life insurance within a 401(k)? As with most things, there are various opinions on the subject. According to Gordon K Williamson in Making the Most of Your 401(k) life insurance in a 401(k) plan is:
A way of getting a deduction for part or all of the premiums being paid.
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A conservative investment, part of which can become moderate or aggressive.
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A certain degree of guarantee to both the employer and the employee.
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A means of partially or fully avoiding certain IRS penalties.
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A reduction in administrative costs for the employer.
Advantage
Advantage: a way of getting a deduction for part or all of the premiums being paid. The contributions made to the participant's 401(k) by the employer are fully deductible by the employer and the participant does not need to report such contributions on their tax return. Within certain limits, premiums paid to buy life insurance within a 401(k) may also be deductible. If the benefits end up being too large, the participant will be taxed on what the IRS considers excess. The positive side of this is that the table used to determine the taxable portion of such contributions, known as P.S. 58, downplays the real economic benefit of such excess. This means that if there are taxed due, it is normally a bargain compared to the value of the insurance the person bought.
Advantage
Advantage: A conservative investment, part of which can become moderate or aggressive. Cash-value insurance uses part of the premium for the cost of the actual life insurance protection and the remainder is invested. The premium that is put into the investment portion can be invested into moderate to aggressive types of cash-value policies. Cash-value insurance can include:
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Whole Life,
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Universal Life
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Variable Life
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Single-Premium Life
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Modified Life
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Limited Payment Life
Traditional Whole Life insurance is usually invested conservatively with a guaranteed rate as well as a guaranteed death benefit. The actual rate of return often ends up being higher than the guaranteed rate, but regulations require that the minimum growth rate be shown.
Universal Life insurance invests in money market type accounts. This means that there will always be growth, but the actual rate of return will depend on the general level of interest rates. Unlike the cash value of traditional whole life insurance, the cash value of universal life grows at a variable rate. Universal life offers a competitive rate when compared to other money market instruments. However, that rate may not always be appealing.
Variable Life insurance allows the participant of the 401(k) plan to decide how the investment portion of the premium (the cash value) will be invested. Investment choices are limited by what the insurance company offers. Some variable life policies offer only a few choices, while other policies will offer a wider array of choices. Investment selection can be changed during the year. The employee participates in the good and bad of the investment choices made. However, regardless of what happens, certain guarantees remain for both employer and employee.
Advantage
Advantage: A certain degree of guarantee to both the employer and the employee. The employer knows the cost of the insurance in advance. The costs may be fixed depending on the coverage. The employee has the assurance that their loved ones will be protected and provided for, as well as the minimum death benefit amount.
Advantage
Advantage: A means of partially or fully avoiding certain IRS penalties. If life insurance is part of the 401(k) plan, a loan taken out of the qualified retirement plan will not be subject to IRS's 15 percent penalty, known as the excess accumulation tax since it is considered "pure insurance" and not an investment.
Advantage
Advantage: A reduction in administrative costs for the employer. A 401(k) plan that includes only life insurance, known as a fully insured plan, is exempt from certain administrative requirements, resulting in lower compliance costs. Because some insurers aggressively market their services to 401(k) companies, the setup costs are lower and the ongoing expenses may also be lower.
Getting Insurance Coverage Within The 401(k) Plan
There are two ways for the company to offer insurance: with or without a medical examination. Using a medical examination often results in lower rates, since anticipated costs can be estimated.
Whichever option is chosen, the amount of coverage is usually based on what is contributed on behalf of the employee, or on their expected pension upon retirement. The 401(k) plan may state that each employee will receive a death benefit equal to their projected monthly retirement check multiplied by 80 (or any number that is less than 100).
If the second option is taken, the medical results cannot discriminate against employees who are considered non-highly compensated employees (NHCE). Nor can results discriminate in favor of employees who are considered highly compensated employees (HCE).
IRS & Incidental
Life insurance is allowed to be part of certain qualified retirement plans such as 401(k)'s, but only if it is incidental. This means that is represents less than a quarter of the total cost of the retirement plan. The total cost is measured by adding together all contributions.
IRS has come up with two tests since this measure is not always easy to determine:
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The first test states the participant's insured death benefit cannot be greater than their expected monthly retirement benefit multiplied by 100.
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The second test states cumulative premiums paid on behalf of the participant must at all times be less than 50 percent of the plan contributions for the same participant of traditional whole life insurance. The percentage changes to 25 percent if term or universal life insurance is being used.
Getting Back To The NEED
So who needs life insurance?
Consider a married couple with a home bearing a large mortgage. Both work and both contribute to the mortgage. Each hopes that if he or she dies, the other will be able to stay in the house, something that would normally not be possible if either of their incomes ended. In this instance, both husband and wife would need life insurance.
Then consider a married couple with a home bearing a mortgage where only one of the spouses works. The other takes care of a disabled child or parent. Could the surviving spouse keep up with the mortgage or afford to pay for the care of the disabled child or parent if the breadwinner died?
In both instances if a spouse had an investment portfolio with approximately the same value as the outstanding mortgage, there would be no need to insure that spouse unless the investment was not liquid.
End of Chapter 8
United Insurance Educators, Inc.
