3952 / May the cost of life insurance protection provided under a qualified plan be recovered tax-free when benefits are paid?

If life insurance protection under a plan is provided by a cash value policy and the employee has reported the pure death benefit each year, then the total amount reported will be the basis in the contract ( Q 3948, Q 3949). That basis may be recovered tax-free if it is paid as a death benefit directly to the beneficiary of the participant.

If a contract is distributed to a participant as a benefit, then the basis in that contract is not taxable.¹ It does not matter whether the contract is distributed or is cashed in and that amount is distributed. It would seem that deductible employee contributions that have been applied to purchase life insurance and taxed to the employee also would be recovered tax-free from benefits received under the policy.² The amount recoverable is the total amount of income that has been reported, and not just the taxes paid on that income.³

Regulations say that “each separate program of the employer consisting of interrelated contributions and benefits” is a single contract. Where retirement benefits and life insurance are separately provided (e.g., through retirement income contracts and a side fund), they generally are separate programs. Thus, if insurance is provided under a separate term policy, the taxable cost cannot be recovered from the retirement benefits.⁴

Where a plan was amended to eliminate death benefits for employees dying prior to age 65 and its trustees redeemed the whole life insurance policies and invested the proceeds in various securities, the plan became a single program of interrelated contributions and benefits; the employees then could recover their taxable insurance cost from distributions from the plan.⁵

Where, under a combination plan, the trustee surrendered the life insurance policy and used both the policy’s cash surrender value and the auxiliary fund to purchase an immediate annuity for a retiring employee, the employee could not recover the taxable insurance costs from the annuity payments; the result would have been different had the auxiliary fund been applied to a settlement under the life insurance policy.⁶

Similarly, where life insurance policies were surrendered and the value used to provide a cash lump sum distribution, the costs taxed to the employee under Table 2001 or P.S. 58 ( Q 3948) were not part of the employee’s cost recoverable from the distribution. Thus, they could be included in the amount rolled over ( Q 4000).⁷

Where nondeductible employee contributions have been earmarked under plan provisions for payment of the cost of life insurance protection, a letter ruling provided the following guidelines: (1) if the life insurance contracts are surrendered by the trustee and payment is made as a lump sum distribution or otherwise, the employee’s basis is the amount of the employee’s nondeductible contributions to the plan that were not applied to the cost of life insurance protection, and (2) if the life insurance contract is distributed as part of the distribution, the employee’s basis is (x) the amount of the employee’s nondeductible contributions to the plan, including those applied to the cost of life insurance protection, plus (y) any additional amounts taxed to the employee as the cost of life insurance protection under Table 2001 or P.S. 58 ( Q 3953).⁸ For estate tax results, see Q 3993.

Keogh Plans

A self-employed individual does not include any costs the individual paid for life insurance protection ( Q 3948, Q 3949) in the individual’s cost basis of benefits received under the contract.⁹ Rather, a self-employed individual loses the tax deduction for the part of the employer’s contribution that is allocable to the cost of pure insurance protection for himself or herself.

In other words, the income tax deduction must be based on the balance of the premium after subtracting the one year term cost of the current life insurance protection.¹⁰

The premium attributable to a waiver of premium provision may not be deducted.¹¹ If any trust earnings are applied to purchase life insurance protection under a trusteed plan, however, a self-employed individual must include the cost, ( Q 3948, Q 3949) in gross income.¹² The life insurance cost is determined in the same manner as for regular employees ( Q 3948, Q 3949). The cost of life insurance protection included in income may not be included in an owner-employee’s cost basis.¹³