While life insurance is generally a prohibited investment for retirement accounts, participants in a qualified retirement plan, or QRP, can purchase policies under certain rules. For example, in a profit-sharing plan, contributions become "seasoned" two years after deposit or after five years of participation in the plan, and up to 100% of that money can be used to purchase life insurance. If a participant chooses to buy any type of life policy within a QRP, contributions for premiums are considered tax-deductible just like other contributions to the plan. Ordinarily, life insurance premiums outside of a QRP are considered after-tax dollars and not deductible.
Depending on the selected life insurance type, some tax may be due while it is owned within the qualified account. Any cash value a policy has is considered income to the participant and is taxable along with other earnings. The insurance cost, however, is not taxable. Therefore, term life policies that do not accumulate any cash value have no tax implications while owned within a QRP, while whole life and variable or universal life policies could be taxed.
Upon retirement, the policy must either be cashed out or distributed to the participant. Taxation is determined by which of three options the participant chooses. The policy can be cashed out with proceeds deposited to the account with no taxes due, as the money becomes identical to other money in the account. If the participant chooses to have the policy distributed in-kind, income tax is owed on the entire value of the policy, minus premiums. Finally, the participant can buy out the policy, which is taxable, but this involves a large sum of cash to be paid in full. Also, this transaction can sometimes fall under the prohibited transactions category. Seek proper tax advice prior to making a decision.