Use Pre-Tax Money to Buy Life Insurance

“Hey,” you think, why not buy the life insurance with my IRA money, and then I will be using pre-tax money.” Right you are. There’s only one problem. Life insurance is not an allowed investment in an IRA. It is a permitted investment in a qualified plan, however. Quickly thinking, you now want to know, “How can I convert my IRA to a qualified plan?”

This is potentially doable if you can report selfemployment income. Perhaps you’ve been running your son’s business when he’s on vacation. Have him pay you as a contractor, and you now have a consulting business and you could use that income to fund a qualified plan. More importantly, you can roll your IRA funds into this qualified plan and buy all of the life insurance you desire (there is a limit on the amount of life insurance you may buy with fresh contributions, but if the money in the IRA was contributed at least two years prior, it can all be used for life insurance premiums).

The IRS has a couple rules on how to do this. It would be too simple to just buy the policy. The IRS needs to add some complexity by stating that there are actually two parts to the policy you are about to buy—there is the portion of the premium that goes to buy the death benefit and the portion of the premium that goes toward the cash value. (You don’t want to buy term insurance in a retirement plan because you could exhaust the retirement plan before you die and have nothing. With term insurance, you pay each year and have coverage only for that year. As you age, the premiums get larger and larger and you could run out of money. Instead, you buy cash value or “permanent” insurance so that there will be a policy still in force when you die).

Back to the two parts of the policy. Each year, the part of the premium that pays for the death benefit is taxable to you. It’s as if the retirement plan was handing you cash to insure your life and thus, you are receiving taxable income. This fortunately is a small part of the total premium (as an example, for a 50 year-old male, the taxable amount to the insured is $230 for a $100,000 policy—see IRS Notice 2001-10 and table below). The large part of the premium is considered an investment, as going toward the cash value of the policy and is not taxable while it’s inside the plan.

Now, let’s consider the morbid situation—you die and the policy is in the plan. Here’s the good news—the pure death benefit that pays off to your heirs is not income taxable. The cash value part of the policy is taxable as it becomes an asset of the retirement plan, which will eventually be taxed upon distribution. Note that the IRS has arranged this pretty favorably in that when the premiums go into the policy, a small part, the part that pays for the death benefit, is taxable to you (see table below). When the policy pays off, because you have paid tax on the premiums that paid for the death benefit, the death benefit, the big part, comes out tax-free.

Table 6.1 (1)

Interim Table of One-Year Term Premiums

For $1,000 of Life Insurance Protetion

As good as this may sound, we can make it better. We generally don’t want the death benefit in your estate as your estate could be subject to estate taxes and the death benefit will be included. So here’s the fix. At some point during your lifetime after age 59½, you will distribute the policy from your plan to yourself (a taxable event) and gift it to your heirs. This will remove the policy from your estate. Let’s slow down and look at these two transactions.

(1) From IRS Notice 2001-10.