Heads Up or Headache – Purchasing Life Insurance Inside a Qualified Plan

Heads Up or Headache – Purchasing Life Insurance Inside a Qualified Plan

I like the way I earn my living, writing and editing, but some days I feel that remaining in bed, head firmly covered, seems the best course.

Our subject today is purchasing life insurance inside the confines of a qualified retirement account. The idea was sold to me as simple perfection, an enriching idea that clients would welcome and agents grasp with a swiftness. It hasn’t turned out so simple.

P.G. Woodhouse, the English author responsible for the endearing Bertie Wooster, the inimitable Jeeves and redoubtable Psmith (the ‘p’ is silent), partnered with many delightful characters in idyllic country mansions, was asked to describe his writing process. He was successful with novels, short stories, Broadway musicals, anything a writer could dream. Let’s give an ear to learn his fine-honed technique.

“Well,” I’m pretty sure he started, “I sit down at the typewriter and swear a bit.”

There we have my Wednesday. Not that I use a typewriter; many readers will need Google to picture these things, and likely go goggle-eyed at their variety and complexity, gormlessly facing the notion of a mechanical writing device.

Typewriters dominated the writer’s life since their invention in 1868, yet they disappeared suddenly. I hear there’s one factory in India, cranking them out for hipsters – whatever gets those doozeys through their caffeine-jolted nights is OK by me, but  I bought my first word processor from Sears in 1987. It was as high tech as a bicycle, all flickering green screen, but it just worked. No more ribbon-stained fingers for me.

Back to our expletive-inducing theme. It sounds simple: some qualified plans allow participants to buy life insurance alongside the usual investments, like mutual funds, bonds and so on. On first glimmer, it looks brilliant. Life premiums are paid with pretax dollars. That’s the beauty of qualified plans: your contributions are deducted from taxable income, reducing the year’s tax bill. If you buy life insurance outside a retirement plan, as commonly the case, the dollars employed are taxable. We seem to have uncovered an appealing tax dodge.

Also, consider the death benefit. It’s a no-joy-in-the-morning sort of bonus, yet it buys restful nights and your loving heirs will genuflect to your spirit for anticipating their burdens. Life insurance as part of a qualified plan is generally available to all participants, including those who might otherwise not qualify for, or be able to afford, life coverage. There’s a good dose of asset protection here, too, as benefits of ERISA-defined plans cannot be snatched away by creditors.

I’ve used a few terms here that may need defining; foundational notions are often unclear. I know people with 401(k) plans who hate the stock market and would never dream of participating. A cousin told me it was immoral to work for an investment bank, as I then did, and why didn’t I do something useful, like building a bridge. Liberal arts wasters as a rule don’t get hired as engineers, but they do learn sharp wit, so we tell ourselves.

“Bridges are paid for by bonds, structured by investment banks,” I retorted. Bonds? Structured? It turned into a long conversation that our Campari and sodas failed to facilitate.

ERISA is a wonderful thing. It’s proud full name is the Employee Retirement Income Security Act of 1974, a time when a name told you what the thing did. Rogue employers back then sometimes played jiggy with pension funds. Studebaker-Packard, makers of gilded chariots since the engine went internally combustible, by-worded their good name by bankrupting the firm with the pension fund bareish. Teamster Pension Fund loans infamously went to finance old-school Vegas casinos, but I’ll say no more; there’s plenty of holes in the desert and I’d rather remain outside of them.

The government acted and implausibly enough, they did the thing right. Regs were nailed down to keep employers focused on their fiduciary duties to working stiffs. Misusing pension funds became harder, reporting solidified, terms were defined, plan participants gained the right to sue, and tax rules were nailed down. Today, when we say a ‘qualified retirement plan’, we mean one that meets the legal requirements, particularly those watched by the IRS.

Good old ERISA. It allows qualified plans to buy life insurance and offer it to employees. Sometimes it comes as part of the plan and in other cases, the participant can decide to opt in or out. Life insurance isn’t an option, as we and the pandemic will argue. Given the chance to fly with all the apparent advantages, why wouldn’t you wing it?

I’m sad to report that it’s kind of a mess. The qualifying rules for buying and holding life policies inside qualified plans are intensely complex, the reporting demanding, and the tax implications hair-raising. This strategy is a bear.

I tried writing a clear summary several times and did ever the expletives fly. My sole counsel is this: if your plan offers life insurance, seek expert advice before clicking the box. This isn’t a self-help scenario.

There is one exception. High-net-worth individuals who need life insurance sometimes balk at tying up dollars in premiums, when they could elsewhere be invested more lucratively. Rich folk favor permanent life, whole and universal, for the cash account and many other benefits, both now and in retirement – yet it’s costly. Those who can buy life insurance inside a profit-sharing retirement plan are model customers for this strategy. Their plan contributions pay the life premiums, and calculations of my acquaintance suggest the long-term savings potential is strong.

This isn’t a self-help strategy, even for sophisticated investors: it requires expert advice, the kind HNW customers generally employ. If it sounds good to you, raise the issue with your advisory team, if they haven’t prompted you themselves.

Before anyone cries ‘privilege’, when measuring the wealthy folk’s benefits, consider their headaches – I have lots of rich friends and I see their pains, the tradeoffs and risks. Not that they need sympathy. Yet my head aches sufficiently. Yes, pity the poor writer, staring long at his screen, longing for days of mechanical and investment simplicity.

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