Life insurance in a 457(b) eligibile plan (tax exempt)

[Scuba 401]

is the death benefit taxable to the spouse? does it matter if the employee is still employed? if the employee separates from service and is still alive what happens to the life insurance inside the plan?

[Carol V. Calhoun]

Yes, the death benefit is taxable to the spouse, regardless of whether the employee was still employed immediately prior to death. (I'm seriously hoping that the employee was not employed after death!) Assets of a 457 plan must be held by the employer, or by a rabbi trust considered part of the assets of the employer. Thus, they do not actually fund the benefit; they merely serve as measurement of the amount of the benefit. And distributions from a 457 plan are taxable to the employee, regardless of what assets are used to measure the benefit.

If the employee separates from service and is still alive, again the life insurance merely measures the amount of the benefit, and the employee is taxable on the benefit received. If the employer chooses to distribute benefits in the form of a life insurance contract, then the fair market value of that contract is taxable to the employee.

[jpod]

The employer or a Rabbi Trust is the owner of all the assets held under the Plan; in either case the employer is the owner for tax purposes. Don't we need to know more about the arrangement for designating the spouse as the death beneficiary and how the premium is being paid before we know whether the death proceeds are taxable or tax-free?

[QDROphile]

We would only need to know more if it made a difference. What difference would any of those elements make? The 457(b) plan has terms that describe what the benefit is, translatable in some way to dollars. All of the benefit dollars are taxable to the recipient. How the employer comes up with the dollars from its own assets is not a part of 457(b).

I am curious about other compliance issues, such as the annual limit to benefit accrual. Are the "contribution" and "earnings" part of the benefit terms related to the terms of the life insurance policy (e.g. premiums, cash value, death benefits)?

[jpod]

If an employer pays for an employee's life insurance coverage and the employee's spouse is the death beneficiary, why wouldn't the death proceeds be tax-free to the spouse? Sure, the premium payments may be taxable as current compensation, but I am struggling to figure out why the fact that premiums are funded with the employee's pre-tax 457(b) contributions, or perhaps the employer's tax-deferred 457(b) contributions, make any difference.

[Peter Gulia]

An answer is at 26 C.F.R. 1.457-1(b).

For those who want more reasoning than 'because the government agency said so', the logic seems to be that the insurance is not the employee's or insured's coverage; it is the employer's coverage. The participant's right is her employer's contract promise to pay deferred compensation according to the plan's terms to the participant or her third-person beneficiary.

[jpod]

FGC: Can you try that citation one more time?

[QDROphile]

Try Treas. Reg. section 1.457-8(b).

[Peter Gulia]

QDROphile, thank you for the correction.

Also, 1.457-10(d).