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Cost of Insured Death Benefit Coverage in Qualified Retirement Plans

Generally, as required by IRC 72(m)(3) and regulation 1.72-16, participants (nonowner employees) of retirement plans qualified under IRC 401(a) are to receive a 1099-R with code 9 in box 7 for each income tax year to report the amount to be included in gross income from insured death benefits funded from employer contributions that are IRC 404 deductible. (Employer contributions for owner-employees allocated for insurance are not deductible.) This cost is commonly known as P.S. 58 costs or Cost of Current Life Insurance Protection. Below are questions with answers to help with these requirements and include references for further research.

What insurance products may cause a P.S. 58 cost from a retirement plan? Any insurance contract that provides a benefit greater than its cash value upon death may cause these taxes. This can be life insurance, annuities, endowments, or other contracts. [1.72-16((b)(4) -> 1.72-2]
Do all retirement plans need to have 1099-Rs issued to participants for coverage of insured death benefits? No, only plans where the terms of the plan are to pay (directly or indirectly) all the insurance policy proceeds to the participant or their beneficiary. [1.72-16(b)(1)]

If the plan has the discretion of paying the proceeds to the participant or beneficiary, then taxes due under 72(m)(3) do not apply. [1.72-16(b)(6)]. If these discretionary proceeds are paid to the participant or beneficiary upon death, then IRC Section 101 for exclusion of certain death benefits from taxable income does not apply. [1.72-16(c)(4)]

Are 1099-Rs required for each year a plan has a policy with death benefits? Generally, yes. However, only tax years where 404 deductible employer contributions (or earnings thereon) were applied have taxes due. [1.72-16(b)(2)]
What is the “year” considered for P.S. 58 costs, and when is the 1099-R due? It is the tax year of the participant. [1.72-16(b)(2)]. Unless an individual filed an approved IRS form 1128, the tax year is the calendar year. The first 1099-R due date is January 31 each year. See IRS instructions for the various 1099-R due dates.

A 1099-R doesn’t need to be filed if it is reporting less than $10 of income.

How much benefit is considered for the tax? During their tax year, it is the largest amount payable upon death during the year that exceeds the cash value as of yearend. [1.72-16(b)(3)]

If the life insurance amount exceeds the Incidental Life Insurance Limits requirements, are 72(m)(3) taxes due? Arguably, no. This is because Incidental Life Insurance Limits are a qualification requirement in regulation 1.401-1. If not a qualified plan, there are other more significant tax consequences. Seek legal counsel for guidance. Suppose the terms of the plan limit the amount payable to the participant and beneficiary from the contract to Incidental Life Insurance Limits, are the excess benefits taxable? Again, arguably no because 1.72-16(b)(1) requires that all proceeds be transferred to the participant or beneficiary to be subject to this requirement. Notice 2004-20 holds that employer contributions used to purchase life insurance in excess of the plan benefits are not deductible when contributed and are carried over to future years for a possible deduction. Since 1.72-16(b)(2) requires that the contributions are 404 deductible and Notice 2004-20 prevents the deduction of excess benefits, then the P.S. 58 cost may arguably wait until the excess benefit becomes deductible to be taxed. Seek legal counsel for guidance.

Notice 2004-20 holds further that if the policy has more than $100,000 excess death benefits over the terms of the plan and has deducted the contributions used for the policy, then this is a Listed Transaction subject to disclosure requirements and penalties. Seek legal counsel for guidance.

How much tax is due from the insured coverage of death benefits? The latest IRS notice is Notice 2002-8. It provides Table 2001 for determining the amount to include in gross income. Instead, if the insurer’s published premium rates that are available to all standard risks for initial issue one-year term policies are both made known to any person who applies for term coverage of that insurer, and the insurer regularly sells the term insurance at those rates through normal distribution channels, then those insurance provider’s rates may be used instead.

Example 1 using Table 2001. An annual premium policy purchased by a qualified trust for a common-law employee provides an annuity of $100 per month upon retirement at age 65, with a minimum death benefit of $10,000. The insurance payable if death occurred in the first year would be $10,000. The cash value at the end of the first year is 0. The net insurance is $10,000 minus $0, or $10,000. Based on Table 2001, for an employee with an attained age of 59 is $6.06 per $1,000 of coverage. The premium for $10,000 of life insurance is $10,000 / $1,000 x $6.06 or $60.60. This is the amount to be reported as income by the employee for his taxable year in which the premium is paid.
Example 2 using Table 2001. Assuming that the cash value at the end of the second year is $500, the net insurance would be $9,500 for the second year. With a net 1-year term rate of $6.51 from Table 2001 for the employee’s age in the second year, the amount to be reported as income to the employee would be $61.85.

Do these P.S. 58 costs build a basis in the contract for the participant? Yes, however, this only applies to the contract providing the life insurance. [1.72-16(b)(4)]. If the contract is surrendered within the plan, the basis is lost. [Rev. Rul. 67-336] If the plan permits and the participant takes the contract in their distribution, then they can apply the basis (all their PS 58 costs due to the coverage over the years) to reduce the income taxes on that distribution. [Written Determination 8125016]

Per 1099-R instructions, the P.S. 58 basis due to 1.72-16 is reported in Box 5 and only if the life insurance contract itself is distributed. A policy is distributed if it is changed from under the plan's name to the participant's name.

If the participant takes the contract with the life insurance in their distribution, can they roll over the basis in the contract due to the P.S. 58 costs? No. Regulation 1.402(c)-2(b)(3) excludes as eligible for rollover the amount that is excludable in their gross income due to the return of their basis under IRC 72.
- If the policy is not transferred to the participant, then the P.S. 58 costs are ignored (treated as zero) for what is eligible for rollover. [Private Letter Ruling 7902083]

The above details do not cover all situations and don’t include all guidance issued on this topic and, as such, shouldn’t be relied upon as guidance. Review the references above and official guidance to determine what is appropriate for each retirement plan and participant. If uncertain as to what is relevant, seek legal or tax counsel.