A qualified plan may provide a death benefit over and above the survivorship benefits required by law, even without using life insurance. In a defined-contribution plan, probably the most common form of death benefit is a provision that the participant�s vested account balance will be paid to the participant�s designated beneficiary if the participant dies before retirement or termination of employment. Defined-benefit plans, unless they use insurance as discussed below, usually do not provide an incidental death benefit; in such cases, the survivors receive no death benefit other than whatever survivor annuity provision the plan provides.

However, a qualified plan must generally purchase life insurance in order to provide any substantial preretirement death benefit. This gives the plan significant funds at a participant�s death, which is particularly important in the early years of his or her employment when the amount contributed on the participant�s behalf is still relatively small.

An insured preretirement death benefit can be provided in either a defined-benefit or defined-contribution plan. Contributions to the plan by the employer may be used to pay life insurance premiums as long as the amount qualifies under the tests for incidental benefits.

In general the IRS considers that nonretirement benefits�life, medical, or disability insurance, for example�in a qualified plan will be incidental and therefore permissible as long as the cost of providing these benefits is less than 25 percent of the cost of providing all the benefits under the plan. In applying this approach to life insurance benefits, the 25 percent rule is applied to the portion of any life insurance premium that is used to provide current life insurance protection. Any portion of the premium that is used to increase the cash value of the policy is considered to be a contribution to the plan fund that is available to pay retirement benefits, and it is not considered in the 25 percent limitation.

The IRS has ruled, using its general 25 percent test, that if a qualified plan provides death benefits using ordinary life insurance (life insurance with a cash value), the death benefit will be considered incidental if either (1) less than 50 percent of the total cumulative employer contributions credited to each participant�s account has been used to purchase ordinary life insurance, or (2) the face amount of the policy does not exceed 100 times the anticipated monthly normal retirement benefit or the accumulated reserve under the life insurance policy, whichever is greater. In practice defined-benefit plans using ordinary life insurance are usually designed to take advantage of the 100-times rule, while defined-contribution plans, including profit-sharing plans, that use ordinary life contracts generally make use of the 50 percent test.

If term insurance contracts are used to provide the death benefit, then, because the 25 percent test will be applied to the entire premium, the aggregate premiums paid for insurance on each participant should be less than 25 percent of aggregate additions to the employee�s account. Term insurance is sometimes used to fund death benefits in defined-contribution plans but rarely in defined-benefit plans.

The IRS has not yet ruled on the use of universal life insurance and similar products in qualified plans, but it informally takes the position that the total premiums for such products must meet the same 25 percent limit as that for term insurance. This is almost certainly incorrect, however, since a substantial part of the premium for a universal life policy, as for an ordinary life policy, goes toward increasing the cash value. The limit in theory therefore should be higher than 25 percent.

The discussion so far is somewhat simplified because insurance can be used in qualified plans in many ways, and the IRS has issued numerous rulings, both revenue rulings and private letter rulings, applying the basic 25 percent test to a variety of different fact situations. Thus there is considerable room for creative design of life-insurance-funded death benefits within qualified plans.

If life insurance is provided for a participant through a qualified plan (that is, by using employer contributions to the plan to pay insurance premiums), part or all of the cost of the insurance is currently taxable to the participant. Life insurance provided by the plan is not considered part of a Sec. 79 group term plan, and consequently the $50,000 exclusion under Sec. 79 does not apply.

If life insurance with a cash value is used, and if all the death proceeds are payable to the participant�s estate or beneficiary, the term cost or cost of the "pure amount at risk" is taxable to the employee. The term cost is the difference between the face amount of insurance and the cash surrender value of the policy at the end of the policy year. In other words, the cost of the policy�s cash value is not currently taxable to the employee because the cash value is considered part of the plan fund to be used to provide the retirement benefit. As discussed earlier, the term cost is calculated using either the PS 58 table of rates provided by the Internal Revenue Service (see table 12-3) or the insurance company�s rates for individual one-year term policies at standard rates, if these are lower and if the insurance company actually offers such policies.

If the plan uses term rather than cash value insurance to provide an insured death benefit, the cost of the entire face amount of insurance is taxable to the employee.

If the plan allows employee contributions, the nondeductible employee contributions can be used to offset taxable income resulting from the inclusion of any form of insurance in the plan. Unless the plan provides otherwise, however, insurance will be considered to have been paid first from employer contributions and plan fund earnings, so this offset is not available unless the plan makes specific provision for it.

Taxation of an insured death benefit received by a beneficiary can be summarized in the following points:

Compared with the tax treatment of life insurance personally owned or provided by the employer outside the plan, there is usually an economic advantage to insurance in a qualified plan, all other things being equal. Insurance outside the plan is paid for entirely with aftertax dollars, so there is no tax deferral. Although the death benefit of nonplan insurance may be entirely tax free instead of partially tax free, the deferral of tax with plan-provided insurance can result in a measurable net tax benefit.

Furthermore, the pure insurance amount of a qualified plan death benefit is not subject to the 15 percent excess accumulation tax of Code Sec. 4980A. PS 58 costs can also be recovered free of the excess accumulation tax. Finally, although qualified plan death benefits are, in general, included in a decedent�s estate for federal estate tax purposes, it may be possible to exclude the insured portion of the death benefit if the decedent had no incidents of ownership in the policy.

A fully insured pension plan is one that is funded exclusively by life insurance or annuity contracts. There is no trusteed (uninsured) side fund. A plan is considered fully insured for the plan year if it meets the following requirements:

Fully insured pension plans were once common, but the high investment returns of the late 1970s lured many pension investors away from traditional insured pension products. Today, however, fully insured plans are coming into their own, and life insurance agents and pension sponsors should take another look at these products. The immediate reason is that recent changes in the pension law�s minimum funding rules have made many noninsured plans "overfunded," and fully insured plans may offer a solution to this widespread problem. But even when overfunding is not a factor, fully insured plans may offer advantages.

Fully insured plans have always been exempt from ERISA�s minimum funding rules for pension plans, and the impact of recent unfavorable changes in the rules makes this exemption even more advantageous.

In addition, fully insured plans are eligible for a simplification of the ERISA reporting requirements (Form 5500 series). An insured plan need not file Schedule B, Actuarial Information with its Form 5500 (or 5500-C/R) and thus does not need a certification by an enrolled actuary. This reduces the cost and complexity of plan administration to some degree. Finally, a fully insured plan is exempt from the requirement of quarterly pension deposits since that is also tied to the minimum funding requirements. Fully insured plans are, however, subject to Pension Benefit Guaranty Corporation (PBGC) coverage and annual premium requirements.

Fully insured funding can be used either with a new plan or an existing plan. The employer can be a corporation or an unincorporated business. Typically, a group type of contract is used, with individual accounts for each participant. All benefits are guaranteed by the insurance company. The premium is based on the guaranteed interest and annuity rates, which are typically conservative, resulting in larger initial annual deposits than in a typical uninsured plan. Excess earnings beyond the guaranteed level are used to reduce future premiums.

Using excess earnings to reduce future premiums results in a funding pattern that is the opposite of that found in a trusteed plan. In the insured plan for a given group of plan participants, the funding level is higher at the beginning of the plan and drops as participants move toward retirement. This maximizes the overall tax deduction by allowing more of it to be taken earlier. It also often permits deductions for an existing plan that has reached the full funding limitation with uninsured funding. By comparison, a traditional trusteed plan starts with a relatively low level of funding, which increases as each participant nears retirement.

A lump-sum insured death benefit is often provided in a fully insured plan in addition to the preretirement survivor annuity required by law in most plans. If so, the total death benefit must not exceed the incidental limits. For example, if the lump-sum benefit is at the maximum limit, it can be reduced by the actuarial present value of the preretirement survivor annuity.

In addition to cash death benefits, insured or otherwise, death benefits can be provided in the form of annuity options with survivorship features�that is, annuities that continue partial or full payment to a beneficiary after the death of the participant. Survivorship annuities for the participant�s spouse are required in certain cases. However, survivorship annuities for the spouse in a form somewhat different from the qualified joint-and-survivor annuity or survivorship annuities for beneficiaries other than the spouse can be included as benefit options in a qualified plan. These options must not exceed the plan�s incidental limits for death benefits.

It is relatively uncommon for a qualified plan to provide term life insurance to participants because the tax treatment provides no advantage to the employee. It is more common, however, to use cash value life insurance as funding for the plan because the PS 58 rates or the insurance company�s term rates may prove to be a relatively favorable way to provide life insurance.

The decision whether to include life insurance in a qualified plan depends on the plan�s objective. The employer must first decide whether and to what extent it will provide death benefits to employees�under a group term or other plan or as an incidental benefit in a qualified plan. The death benefit should be designed to produce the lowest employer and employee cost for the benefit level desired. A death benefit should be included in the qualified plan only to the extent it is consistent with this objective.

A Keogh plan is a qualified plan available to a proprietor or one or more partners of an unincorporated business. Life insurance can be used to provide a death benefit for regular employees covered under the plan, and the rules discussed in this chapter apply. Life insurance can also be provided under the plan for a proprietor or partners, but the tax treatment for proprietors and partners is slightly less favorable.

Life insurance can also be used to provide an incidental benefit under a tax-deferred annuity plan on much the same basis as in a qualified profit-sharing plan. Covered employees will have PS 58 costs to report as taxable income, as in a regular qualified plan.

Life insurance contracts are not permissible investments for an individual retirement plan (IRA). In effect, this means that an IRA cannot provide an insured death benefit. Similarly, a SEP (simplified employee pension) plan cannot purchase life insurance since SEPs are funded with individual IRA contracts.