Section 412(e)(3) Plans
Life Insurance Inside a 412(e)(3) Plan: Limits, Taxation and the Listed Transaction
Published October 8, 2026 · Updated October 9, 2026
Technical summary / key takeaways
- A participant's death benefit under a 412(e)(3) plan is subject to the incidental death benefit rule. The plan's purpose is a retirement benefit, and the IRS lists that rule among the points its examiners check.
- A plan is described in 26 U.S.C. § 412(e)(3) only if it meets all six conditions in subparagraphs (A) through (F). Only then does the exemption from the minimum funding rules apply.
- Notice 2002-8 provides Table 2001 for valuing current life insurance protection in a qualified retirement plan. Table 2001 took the place of the older P.S. 58 rates for most purposes.
- Under Rev. Rul. 2004-20, an arrangement the same as or substantially similar to the ruling's Situation 2 is a listed transaction when the employer has deducted premiums for a contract whose death benefit exceeds the participant's death benefit under the plan by more than $100,000. Failing to disclose a listed transaction carries a penalty under 26 U.S.C. § 6707A.
- Under 26 C.F.R. § 1.402(a)-1(a)(1)(iii) and Rev. Proc. 2005-25, a distributed contract is valued at fair market value. That value includes the cash value and all other rights under the contract.
- Section 264(a)(1) bars a deduction for premiums when the taxpayer is directly or indirectly a beneficiary under the policy. Qualified-plan contributions are deducted under § 404, and how the two rules meet turns on the facts of the plan.
Technical Summary: Life Insurance in a 412(e)(3) Plan
Life insurance can sit inside a 412(e)(3) plan, which is a fully insured defined-benefit plan, but the participant's death benefit under the plan must be incidental to its primary purpose of providing retirement benefits. The participant is taxed each year on the cost of the insurance protection. Under IRS guidance, deducting premiums for a death benefit more than $100,000 above the plan's death benefit is a listed transaction.
The readers who ask this question are usually owner-employees, partners and finance leads of closely held businesses and professional practices. Their business problem is funding a defined retirement benefit for the owners. Life insurance contracts are one possible funding mechanism inside that plan, and they bring their own tax rules. A 412(e)(3) plan must meet the six conditions of 26 U.S.C. § 412(e)(3)(A)-(F). Contributions are deductible only within 26 U.S.C. § 404, and benefits are limited by 26 U.S.C. § 415(b). The yearly insurance cost is measured with Table 2001 under Notice 2002-8. A contract that is distributed is valued under 26 C.F.R. § 1.402(a)-1(a)(1)(iii) and Rev. Proc. 2005-25. Before the Pension Protection Act of 2006, these plans were known as 412(i) plans. The broader plan is explained on the site's page on the 412(e)(3) plan.
What "Life Insurance in a 412(e)(3) Plan" Means
The term "fully insured" is literal. Section 412(e)(3)(A) describes a plan "funded exclusively by the purchase of individual insurance contracts." These may be annuity contracts, life insurance contracts or both. A defined-benefit plan is a plan that promises a stated retirement benefit, rather than an account balance.
The mechanics differ from a business-owned policy. The employer pays contributions to the plan. The contracts are bought from a state-licensed insurance company, either directly by the employer or through a custodial account or trust. Who receives a death benefit depends on the plan's terms and the contracts. That arrangement separates this structure from the ownership patterns described on the site's page on how business life insurance works.
The retirement benefit is the plan's primary purpose. Any life insurance is incidental to it. The phrases "life insurance in a defined benefit plan," "412i life insurance" and "life insurance in a 412e3 plan" usually refer to this arrangement.
According to the IRS, the former § 412(i) provisions "were relocated to IRC Section 412(e)(3), effective for plan years beginning after December 31, 2007." The arrangement is a qualified retirement plan. It is not an executive bonus arrangement, a split-dollar arrangement or a corporate-owned policy, which are separate strategies.
The Federal Rules That Govern This Arrangement
Several separate authorities apply at once:
- 26 U.S.C. § 412(e)(3) sets the six conditions. Section 412(e)(2)(B) excepts such an "insurance contract plan" from the minimum funding rules of § 412.
- 26 U.S.C. § 404(a) provides that contributions to a pension plan "shall not be deductible under this chapter; but, if they would otherwise be deductible, they shall be deductible under this section," subject to its limitations.
- 26 U.S.C. § 415(b) limits the annual benefit. The benefit may not exceed the lesser of a dollar amount stated in the statute (adjusted annually for cost-of-living increases) or "100 percent of the participant's average compensation for his high 3 years."
- 26 U.S.C. § 264(a)(1) provides that no deduction is allowed for "Premiums on any life insurance policy, or endowment or annuity contract, if the taxpayer is directly or indirectly a beneficiary under the policy or contract." How this rule relates to a § 404 contribution deduction depends on the plan and the contracts. The site's page on business life insurance cost covers § 264(a)(1) outside qualified plans.
- 26 C.F.R. § 1.402(a)-1(a)(1)(iii) sets fair market value as the measure for a distributed contract.
- Notice 2002-8 provides Table 2001 for valuing current life insurance protection "in a qualified retirement plan."
- Rev. Proc. 2005-25 explains how to determine the fair market value of a life insurance contract, including for a distribution from a qualified plan. It states that it modifies and supersedes an earlier revenue procedure.
- Rev. Rul. 2004-20 addresses the deduction limits and identifies listed transactions.
- The IRS "Fully insured 412(e)(3) plans" page summarizes the IRS's examination issues for these plans.
Statutory Requirements Under Section 412(e)(3)
Six conditions appear in the statute, and a plan is described in § 412(e)(3) only if it meets all of them:
- (A) "the plan is funded exclusively by the purchase of individual insurance contracts."
- (B) "such contracts provide for level annual premium payments to be paid extending not later than the retirement age for each individual participating in the plan, and commencing with the date the individual became a participant in the plan (or, in the case of an increase in benefits, commencing at the time such increase becomes effective)."
- (C) Benefits provided by the plan equal the benefits provided under each contract at normal retirement age under the plan, and an insurance carrier licensed under the laws of a State to do business with the plan stands behind those benefits to the extent premiums have been paid.
- (D) "premiums payable for the plan year, and all prior plan years, under such contracts have been paid before lapse or there is reinstatement of the policy."
- (E) "no rights under such contracts have been subject to a security interest at any time during the plan year."
- (F) "no policy loans are outstanding at any time during the plan year."
The statute also treats group contracts with the same characteristics, as determined under Treasury regulations, as meeting this description.
A plan that misses any one condition is not described in § 412(e)(3), so the exemption in § 412(e)(2)(B) does not reach it. Rev. Rul. 2004-20 gives an example of a plan that "cannot be a section 412(i) plan." In that example, the contracts provide benefits at normal retirement age greater than the plan's own benefits. The IRS issued guidance in 2004 and 2005, it says, "to stop abuses involving the use of certain specially designed life insurance policies in retirement plans."
How the Life-Insurance Rules Work Inside the Plan
Five sets of rules govern the insurance element.
Incidental benefit. The IRS lists the incidental death benefit rule among its examination issues for these plans. Whether a given death benefit is incidental depends on the plan formula and the contracts.
Annual inclusion. On the participant's yearly income, the IRS page states: "The amount reported as income is equivalent to the premium paid on a term life insurance policy for 1 year for the face value of the plan policy." Notice 2002-8 provides Table 2001 for valuing this protection in a qualified retirement plan. A Treasury regulation on the cost of life insurance protection counts the amounts an employee includes in income as consideration paid by the employee only for benefits attributable to the contract providing the protection, and it provides that amounts an owner-employee includes are not in any case treated as part of his or her investment in the contract. How a later distribution is taxed depends on the participant and the facts.
Distribution value. 26 C.F.R. § 1.402(a)-1(a)(1)(iii) provides: "the policy cash value and all other rights under such contract ... are included in determining the fair market value of the contract." Rev. Proc. 2005-25 explains how that fair market value is determined. A sale of a contract to a participant for less than its fair market value also counts. On or after August 29, 2005, the excess value is "treated as a distribution to the distributee under the plan for all purposes."
Death benefit. Section 101(a)(1) provides that gross income generally "does not include amounts received ... under a life insurance contract, if such amounts are paid by reason of the death of the insured." That exclusion has limits. Under § 101(a)(2), the exclusion is limited after a transfer for valuable consideration. Under § 101(j), the exclusion for an employer-owned contract is capped at premiums and other amounts paid. The cap lifts only if a § 101(j)(2) exception applies and the notice and consent requirements were met before issue. How the portion of the benefit that reflects cash value is taxed depends on the plan's terms.
Contribution deduction. Rev. Rul. 2004-20 states that contributions used to buy coverage "in excess of the participant's death benefit provided under the plan are not fully deductible when contributed." Instead, those amounts are carried over within § 404 limits.
Who This Arrangement Is For
The usual reader owns or helps run a small, closely held business or professional practice. That business wants a defined retirement benefit for its owners and is weighing insurance contracts as the plan's funding. Typical profiles include:
- Businesses with steady cash flow. Section 412(e)(3)(B) calls for level annual premiums for each participant up to retirement age.
- Owner-employees and partners whose retirement benefit, within § 415(b), is the main planning goal. Life insurance in this setting is a secondary feature.
- Employers whose workforce is mostly or entirely owners. The plan must satisfy the qualified-plan coverage and nondiscrimination rules, which the IRS lists as an examination issue.
- Employers that want the benefit backed by insurance contracts rather than a trust portfolio.
The site's page on life insurance for business owners covers insurance uses outside a retirement plan. Whether the arrangement fits a particular business depends on facts this page cannot know, and requires individual review of the plan documents, the contracts involved and the employer's situation by qualified tax, legal and insurance professionals.
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When the 412(e)(3) Structure Applies
Recognition under federal law begins with the plan type. Section 412(e)(2)(A) separately excepts profit-sharing and stock bonus plans, so § 412(e)(3) is a defined-benefit structure. The structure applies when all six conditions of § 412(e)(3)(A)-(F) are met, the life insurance stays incidental, deductions stay within § 404 and benefits stay within § 415(b).
The listed-transaction rule depends on stated facts. Rev. Rul. 2004-20 identifies as listed transactions those arrangements "the same as, or substantially similar to," its Situation 2. That identification is effective February 13, 2004, and applies only if "the employer has deducted amounts used to pay premiums on a life insurance contract for a participant with a death benefit under the contract that exceeds the participant's death benefit under the plan by more than $100,000."
Under 26 U.S.C. § 6707A(c)(2), a listed transaction is a reportable transaction "specifically identified by the Secretary as a tax avoidance transaction." A person who fails to include the required information on a return or statement owes a penalty under § 6707A(a). Under § 6707A(d), the Commissioner's authority to rescind the penalty does not extend to listed transactions. The IRS "Fully insured 412(e)(3) plans" page is the agency's summary of these issues.
When the 412(e)(3) Structure May Not Apply
Several facts take a plan outside the structure or change its tax treatment:
- A missed condition. A plan that fails any one of § 412(e)(3)(A)-(F) is not an insurance contract plan under § 412(e)(2)(B). The minimum funding rules then generally apply to it.
- Excess insurance. The IRS lists the incidental death benefit rule among the points its examiners check. Contracts that pay more at retirement than the plan promises fail the example in Rev. Rul. 2004-20.
- Contributions above § 404. Under 26 U.S.C. § 4972(c)(1), "nondeductible contributions" include contributions above "the amount allowable as a deduction under section 404." Those contributions are subject to the excise tax that section imposes.
- The Rev. Rul. 2004-20 pattern. In an arrangement the same as or substantially similar to Situation 2 of the ruling, deducting premiums on a contract whose death benefit is more than $100,000 above the participant's death benefit under the plan produces a listed transaction.
- Profit-sharing and stock bonus plans. Section 412(e)(2)(A) separately excepts any profit-sharing or stock bonus plan from the minimum funding rules, and § 412(e)(3) is the exception for insurance contract plans. The site compares those plans on its page on 412(e)(3) and 401(k) plans.
- Uneven cash flow. A missed premium that is not paid before lapse, and is not followed by reinstatement, fails § 412(e)(3)(D).
Compliance Considerations for Life Insurance in a 412(e)(3) Plan
Holding life insurance adds recurring tasks to ordinary plan administration. Each year, the cost of current protection is measured with Table 2001 under Notice 2002-8 and included in the participant's income, as the IRS page describes. For a listed transaction, § 6707A(a) imposes a penalty on any person who fails to include the required reportable transaction information on a return or statement. Insurer forms, procedures and timing vary from insurer to insurer and are confirmed with the insurers involved.
The plan document has to reflect the fully insured structure. An amendment that changes the funding contracts, the premium pattern or the benefit formula affects whether the six conditions are still met. When a contract is distributed, its fair market value is determined under 26 C.F.R. § 1.402(a)-1(a)(1)(iii) and Rev. Proc. 2005-25, and how amounts previously taxed are treated depends on the participant and the plan records.
Section 101(j) applies to an "employer-owned life insurance contract," defined as a contract owned by a person engaged in a trade or business that is directly or indirectly a beneficiary and that covers an employee. Whether a contract held by a qualified plan trust is employer-owned within § 101(j), and whether notice, consent and reporting obligations apply, depends on the facts and requires individual review by the insurers involved and a qualified tax professional.
Common Errors in 412(e)(3) Plans That Hold Life Insurance
Several errors follow directly from the rules above:
- Specially designed policies. The IRS describes the use of certain specially designed life insurance policies in retirement plans as the abuse its 2004 and 2005 guidance was issued to stop. Rev. Rul. 2004-20 addresses deductions for coverage beyond the participant's death benefit under the plan.
- Skipping the annual inclusion. Failing to include the Table 2001 cost of protection in the participant's income each year is an error.
- Undervaluing a distribution. Treating a distributed contract as worth only its cash surrender value is an error, because the regulation counts "all other rights under such contract."
- Relying on outdated guidance. Rev. Proc. 2005-25 states that it supersedes the earlier valuation procedure.
- Loans or pledges. An outstanding policy loan fails § 412(e)(3)(F). A security interest fails § 412(e)(3)(E).
- Lapse without reinstatement. Letting a premium lapse without reinstatement fails § 412(e)(3)(D).
- Missing disclosure. Omitting required listed-transaction information triggers § 6707A.
The IRS "Fully insured 412(e)(3) plans" page lists related issue indicators that its examiners use.
Hypothetical Example: Table 2001 Cost and Distribution Value
This example is hypothetical. Every figure in it is a round, illustrative number. None is an actual Table 2001 rate or a real contract value.
Assumptions: a participant covered by a plan contract with $1,000,000 of current life insurance protection; an illustrative rate of $2 per $1,000 of protection; the same figures for 5 years; and a distribution in year 6 at an illustrative fair market value of $200,000.
Step 1: annual inclusion. $1,000,000 ÷ $1,000 = 1,000 units. 1,000 units × $2 = $2,000 included in income for the year.
Step 2: accumulated amounts. $2,000 × 5 years = $10,000 of protection cost included in income over the five years.
Step 3: distribution. The distributed contract is taken into account by the distributee at its fair market value, here the illustrative $200,000.
Actual rates come from Table 2001 at the insured's age. Actual values come from Rev. Proc. 2005-25 applied to the specific contract. Whether amounts previously included in income count toward the cost of the contract depends on the participant and on the plan and contract records.
Professional Coordination for a 412(e)(3) Plan with Life Insurance
Several roles typically meet in one of these plans. An actuary generally works on the benefit formula and on whether it stays within § 415(b). A tax professional addresses § 404 deductions, the Rev. Rul. 2004-20 analysis and the participant's yearly inclusions. A plan administrator handles the plan documents, annual reporting and distribution reporting. An insurance professional typically reviews whether the contracts carry level premiums with no loans or pledges, and supplies contract data used in valuing protection and distributions.
When the plan ends, the plan-termination rules, the plan documents and the contracts decide whether a contract is distributed, surrendered or handled another way. A distribution of a contract is valued under 26 C.F.R. § 1.402(a)-1(a)(1)(iii). Questions about a later exchange of the contract or a term conversion are separate topics that depend on the contract's own provisions. The site's page on business succession life insurance covers ownership transitions that may occur alongside a plan's end.
We're Here for You
We're your trusted California business life insurance advisor. Call us 7 days a week, or send us a message, to have a real conversation about what your business needs.
Frequently Asked Questions
What was a 412(i) plan and is it the same as a 412(e)(3) plan?
Yes, the two labels describe the same type of plan. The IRS states that before the Pension Protection Act of 2006, these plans "were known as '412(i) plans'." The provisions "were relocated to IRC Section 412(e)(3), effective for plan years beginning after December 31, 2007," and the IRS notes that the regulations were not updated after that change.
How is a participant taxed on life insurance inside a 412(e)(3) plan each year?
The participant includes the cost of current life insurance protection in income each year. The IRS describes that amount as equivalent to a one-year term premium for the face value of the plan policy. Notice 2002-8 provides Table 2001 for valuing this protection in a qualified retirement plan.
How is a life-insurance contract valued when it is distributed from a 412(e)(3) plan?
A distributed contract is valued at fair market value, not cash surrender value alone. 26 C.F.R. § 1.402(a)-1(a)(1)(iii) includes "the policy cash value and all other rights under such contract." Rev. Proc. 2005-25 explains how that fair market value is determined.
What makes a 412(e)(3) arrangement a listed transaction?
Under Rev. Rul. 2004-20, the arrangement is a listed transaction when it is the same as or substantially similar to the ruling's Situation 2. It also requires that the employer deducted premiums on a contract whose death benefit exceeds the participant's plan death benefit by more than $100,000. Section 6707A penalizes a failure to include the required information on a return or statement.
What are the six conditions a plan must meet to qualify as a fully insured 412(e)(3) plan?
Section 412(e)(3)(A)-(F) sets six conditions: funding exclusively by individual insurance contracts; level annual premiums from participation to retirement age; plan benefits equal to the contract benefits at normal retirement age, with a licensed insurance carrier standing behind them to the extent premiums are paid; premiums paid before lapse, or reinstatement; no security interest on the contract rights during the plan year; and no outstanding policy loans during the plan year.
Can a 412(e)(3) plan have policy loans or use the contracts as collateral?
No, not while keeping its § 412(e)(3) status. Subparagraph (E) requires that no rights under the contracts were subject to a security interest during the plan year. Subparagraph (F) requires that no policy loans were outstanding during the plan year. A plan that fails either condition is no longer excepted from the minimum funding rules.
What happens to the life-insurance policy when a 412(e)(3) plan terminates?
The answer depends on the plan documents and the contracts. A contract distributed from the plan is valued at fair market value under 26 C.F.R. § 1.402(a)-1(a)(1)(iii). Other outcomes turn on the plan-termination rules and the contract's own provisions.
Educational information only. Not legal, tax, investment or insurance advice. Product availability and outcomes depend on individual circumstances.