3948 / What method is used to determine the cost of current life insurance protection provided in a qualified plan and taxed to employee participants?

The cost of life insurance protection provided under a qualified pension, annuity, or profit sharing plan must be included in an employee’s gross income for the year in which deductible employer contributions (whether deducted in the current year or a prior year) or trust income is applied to purchase life insurance protection.¹ This rule applies whether the insurance is provided under group permanent or individual cash value life insurance policies or term insurance, and whether it is provided under a trusteed or non-trusteed plan.² According to letter rulings, the rule applies as well to the protection under a life insurance policy on a third party if proceeds are allocable to an employee’s account, as can occur with the funding of a buy-sell arrangement.³

An employee is taxed currently on the cost of life insurance protection if the proceeds either are (1) payable to the employee’s estate or beneficiary, or (2) payable to the plan’s trustee, if the plan requires the trustee to pay them to the employee’s estate or beneficiary.⁴

On the other hand, an insured is not taxed on the insurance cost if the trustee has the right to retain any part of the death proceeds.⁵ Thus, an insured is not taxed on the cost of key person insurance purchased by the trustee as a trust investment. Likewise, participants are not taxed on the cost of a group indemnity policy purchased to indemnify the trust against excessive death benefit payments.⁶

The insured does not avoid tax on the current cost of the insurance protection merely because, under the terms of the plan, his or her interest in the policy may be forfeited before his or her death and the trust may receive the cash surrender value of the contract.⁷