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Can You Deduct Life Insurance? The Split-Funded Defined Benefit Plan
Life insurance premiums usually aren’t deductible. Inside a qualified defined benefit plan, part of your deductible plan contribution can pay for life insurance on the owner.
Retirement savings and life insurance, built into one plan.
Put Your Insurance to Work
A free split-funded plan illustration for your business
Is life insurance tax deductible for business owners?
Usually not. Premiums on a policy that protects you, your family, or your business are generally paid with after-tax dollars. The main exception is life insurance held inside a qualified retirement plan.
In a split-funded defined benefit plan, the plan invests part of its assets in traditional investments and uses part to buy life insurance on participants. The business deducts its contribution to the plan, and the plan pays the premiums. Each year, the insured participant reports a modest amount of taxable income for the value of the pure insurance protection, based on IRS tables.
How a split-funded defined benefit plan works
- Your business adopts a defined benefit or cash balance plan. Contributions are set by an actuary and are deductible to the business, often $100,000 to $300,000+ a year for older owners.
- The plan buys a policy on the owner. Part of each year’s contribution pays the premium, within the IRS incidental benefit limits.
- You report the cost of the protection. The participant includes the economic value of the death benefit protection in income each year, using the IRS Table 2001 rates. These amounts build up tax basis in the policy.
- At retirement, you decide what happens to the policy. Most owners buy the policy from the plan at fair market value, personally or through a trust, which isn’t a taxable event and keeps the coverage. The plan can also distribute the policy to you, which is taxable, or surrender it and roll the cash value into the rest of your benefit.
If the participant dies before retirement, the beneficiaries receive the death benefit. The portion above the policy’s cash value is generally income tax free. The cash value portion is treated as a plan distribution.
How much life insurance can a defined benefit plan buy?
Life insurance in a qualified plan must be “incidental” to the retirement benefit. The common safe harbors:
| Test | Limit |
|---|---|
| Whole life premiums | Less than 50% of the contributions made for the participant |
| Term or universal life premiums | Less than 25% of the contributions made for the participant |
| Death benefit test (defined benefit plans) | Death benefit no more than 100 times the projected monthly retirement benefit |
We design the plan and the policy together so the insurance stays within these limits and the plan still funds the retirement benefit it promises.
How We Build Your Plan
From first call to first contribution, we handle the design, the math, and the compliance.
1
Review Your Business
We look at your income, age, staff census, and current plan to see what’s possible.
Design Your Stack
We layer your 401(k), profit sharing, and cash balance plan around your tax goals.
See the Numbers First
You get a clear illustration of your deduction, your savings, and your staff cost before you commit.
We Run It for You
Plan documents, annual actuarial work, testing, and filings, handled every year.
Who should consider a split-funded plan?
- Owners who already want a defined benefit or cash balance plan for the large tax deduction
- Owners who need life insurance anyway for family protection, estate liquidity, or a buy-sell agreement
- Physicians, dentists, attorneys, and other high earners with stable income and room to contribute for several years
- Small businesses with few employees, where most of the contribution benefits the owners
A related design, the fully insured 412(e)(3) plan, is funded entirely with insurance and annuity contracts. It can allow very large deductions but is less flexible. We’ll tell you which one fits.
What to know before you set one up
- Insurance reduces the assets invested for retirement. The plan has to balance protection with funding the promised benefit.
- How the policy leaves the plan matters. If the plan simply distributes the policy to you, its fair market value, less the basis you’ve already reported, is taxable income. You can avoid that by buying the policy from the plan at fair market value, either personally or through a trust. Because the plan is paid full value, the purchase isn’t a taxable distribution, and the money you pay stays in your retirement account. Owning the policy through a trust, such as an irrevocable life insurance trust, can also keep the death benefit outside your taxable estate.
- The IRS watches for abuse. Designs that understate a policy’s value when it leaves the plan have been targeted. We stick to conservative, well-documented designs.
- It’s a multi-year commitment. Defined benefit plans are meant to be funded for several years, so steady income matters.
Life and disability insurance require medical and financial underwriting. Policy guarantees depend on the claims-paying ability of the issuing insurance company. Illustrations are hypothetical and not guaranteed. Tax treatment depends on your facts, so review any strategy with your tax professional.
Michael, a successful business owner with no employees, wanted to maximize his retirement savings while minimizing taxes.
Through a custom-designed retirement plan stack, he and his wife were able to contribute over $575,000 across multiple plans in a single year.
This strategy not only helped secure their financial future but also generated over $222,000 in immediate tax savings, significantly increasing their cash flow and long-term wealth-building potential!
James runs a construction company with high employee turnover and wanted a way to protect cash flow while maximizing retirement contributions.
Through a custom 401(k) and profit-sharing plan design, we used strategic eligibility and vesting schedules to limit costs from short-term employees while allowing ownership to maximize contributions.
This strategy protected company assets, controlled expenses, and helped James build significant retirement wealth.
Eileen, a small business owner, needed a low-cost retirement plan that would meet state mandate requirements while helping her recruit and retain high-quality employees.
Eileen used a customized 401(k) solution focused on minimizing expenses, giving Eileen a competitive edge in hiring without pulling resources away from reinvesting in her growing business.
By using tax credits, her design allowed her to stay compliant, attract top talent, and keep her financial priorities aligned.
*These are hypothetical clients with hypothetical situations and plan designs.
Why business owners work with Life, Inc.
- Everything under one roof. Plan design and administration, investment advisory, and insurance strategies, all from one team. No juggling three different firms.
- A credentialed, in-house team. Our plan specialists hold industry designations including QKA, QPA, and AIF, and handle your plan year round.
- Insurance designed with your retirement plan. Coverage is built to work alongside your 401(k), cash balance plan, and executive benefits, not sold on its own.
- Custom, not cookie-cutter. Every plan is designed around the owners’ tax goals first, then built to pass IRS testing.
- Nationwide. We design and administer plans for businesses across the country.
Learn more: Adding a DB Plan | Cash Balance vs. DB | Tax Strategies for Business Owners | The Retirement Plan Stack | About Us
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Our Most
Asked Questions
Is life insurance tax deductible for a business owner?
Generally no. Premiums on personal or key person policies are paid with after-tax dollars. Life insurance purchased inside a qualified retirement plan, such as a split-funded defined benefit plan, is paid with deductible plan contributions, though the participant reports the value of the protection as income each year.
Can a defined benefit plan own life insurance?
Yes. A defined benefit or cash balance plan can buy life insurance on participants as long as the coverage is incidental to the retirement benefit under IRS rules.
How is life insurance inside a pension plan taxed?
Each year, the participant includes the economic value of the death benefit protection in income, based on IRS Table 2001 rates. At death, the amount above the cash value is generally income tax free to beneficiaries. If the policy is distributed to you at retirement, its fair market value, less reported basis, is taxable. Buying the policy from the plan at fair market value, personally or through a trust, avoids that tax.
Can a cash balance plan hold life insurance?
Yes. A cash balance plan is a type of defined benefit plan, so it can be split-funded with life insurance under the same incidental benefit limits.
What happens to the policy when I retire?
You have three options. You or a trust can buy the policy from the plan at fair market value, which is not a taxable event and keeps the coverage in force. The plan can distribute the policy to you, which is taxable. Or the policy can be surrendered and its cash value rolled over with the rest of your benefit.
What is a 412(e)(3) plan?
It is a fully insured defined benefit plan funded only with life insurance and annuity contracts. It can produce very large deductions in the early years, but contributions are less flexible than a traditional split-funded design.
Is a split-funded plan right if I already have a cash balance plan?
Possibly. An existing defined benefit or cash balance plan can sometimes be amended to hold life insurance, within the incidental benefit limits. We review your plan and coverage needs first.
Some Of Our Trusted Partners:
Life, Inc. Retirement Services does not offer tax advice. Please always consult your tax professional about your eligibility for tax credits.
Life, Inc. Retirement Services is a Registered Investment Advisory Firm of the state of Ohio and licensed in Florida and Maryland. All emails and communication are meant to be informative and educational and should not be considered a sale of security until proper notification and disclosures are given.