Distributing a Life Insurance Policy at Retirement: FMV Rules for Money Purchase Plans

When a money purchase plan owns life insurance on a participant, retirement forces a decision that many plan sponsors and their advisors handle incorrectly: what happens to the policy, and how is it taxed when it leaves the plan? The answer turns on a single concept—fair market value—and on a set of IRS rules that were rewritten specifically to stop the games people used to play with policy valuation.

This article walks through how a life insurance contract is valued and taxed when it is distributed from a money purchase plan, how the participant's basis reduces the tax bill, and the planning options available at retirement. It also flags the traps that are easy to miss, including one that applies disproportionately to owner-employees.

A qualified plan can hold life insurance only as an incidental benefit. In a defined contribution plan like a money purchase plan, that means premiums are capped—generally 25% of contributions for whole life and 50% for term or universal life. Insurance is a supporting feature of the plan, not its purpose.

At retirement, the rationale for holding the policy inside the plan largely disappears. The plan cannot continue to maintain meaningful insurance for a participant who is no longer accruing benefits, and the participant typically wants either the death benefit in personal hands or the cash value as part of their retirement distribution. So the policy has to be dealt with—distributed in kind, purchased by the participant, surrendered, or exchanged. Each path runs through the fair market value rules.

Here is the rule that surprises people: when a life insurance contract is distributed from a qualified plan, the participant must include the fair market value of the policy in income for that year—not its cash surrender value. This comes directly from the income tax regulations governing plan distributions of property (Treas. Reg. §1.402(a)-1(a)(1)(iii) and (a)(2)).

For most assets, fair market value and cash value are the same thing. For life insurance, they historically were not, and that gap was abused.

Before 2004, plans routinely valued distributed policies at cash surrender value. Promoters built a strategy around the fact that certain policies could be designed with temporarily depressed cash surrender value in the early years—high surrender charges, "springing" cash value, and similar features. The plan would fund the policy with the maximum deductible dollars, then distribute it to the participant at a moment when the net cash surrender value was at its artificial low. Shortly after the policy left the plan, the cash value would surge.

The result was a large deduction going in, a tiny taxable distribution coming out, and a valuable asset landing in the participant's hands for pennies on the dollar. The IRS shut this down in 2004 and finalized the fix in 2005.

The 2005 final regulations made clear that fair market value—including cash value and all other rights under the contract—controls. Alongside them, the IRS issued Revenue Procedure 2005-25, which provides two safe harbor formulas for determining that value. Using a safe harbor doesn't guarantee a particular number, but it gives the plan and participant comfort that the IRS will not challenge the valuation.

For a non-variable contract, the safe harbor fair market value is the greater of:

• The reserve-based amount — the interpolated terminal reserve (ITR) plus any unearned premiums, plus a pro rata portion of a reasonable estimate of dividends expected for the policy year; or
• The PERC amount — Premiums plus Earnings minus Reasonable Charges, multiplied by an applicable Average Surrender Factor.

You take the higher of the two. The whole point of comparing them is to prevent cherry-picking a depressed cash surrender value: the PERC amount effectively adds back the surrender charges and acquisition costs the insurer subtracted in the early policy years.

The Average Surrender Factor cannot drive the value below a floor—the safe harbor does not permit a surrender-charge adjustment that takes the factor below 0.70. And where the transfer is governed by IRC §§79 or 83 rather than §402, no reduction for surrender charges is allowed at all.

In practice, you don't compute this from scratch. IRS Form 712, supplied by the insurance carrier, reports cash value, premiums paid, terminal reserve, and the other inputs the TPA or actuary needs. Most carriers will quote a "Rev. Proc. 2005-25 value" on request. Note one detail: dividends held on deposit are added on top of the policy's fair market value—they are not subsumed in the formula.

This is the part of the analysis that matters most at retirement, and it's where the money purchase context becomes concrete.

Every year the plan holds insurance on a participant, the participant must report the cost of the pure death benefit protection as taxable income. This is the PS 58 cost (now measured using Table 2001 rates under Treas. Reg. §1.72-16, or lower carrier term rates if the conditions are met). It is "phantom income"—the participant pays tax on an economic benefit they never received in cash.

The payoff comes later. Those previously taxed PS 58 / Table 2001 costs become basis in the contract. When the policy is distributed, the participant is not taxed again on that basis. The taxable amount is:

Fair market value of the policy − cumulative PS 58/Table 2001 costs already taxed − any after-tax contributions = taxable distribution

So the annual phantom income isn't a pure cost; it's a prepayment that reduces the tax due when the policy leaves the plan.

Assume a money purchase plan participant retires with a whole life policy that has:

Here is the caveat that catches sponsors of small money purchase plans, where the participant is frequently the business owner: the favorable basis recovery rule does not apply the same way to a self-employed individual.

PS 58 / Table 2001 costs create recoverable basis for common-law employees. But for a self-employed person—a sole proprietor or a partner in a partnership—those costs generally are not treated as recoverable basis on distribution. Because so many money purchase plans are owner-only or owner-heavy, this distinction can materially change the after-tax outcome for exactly the person making the decision. If the insured participant is taxed as self-employed, run the numbers without assuming the PS 58 offset.

This is precisely the kind of detail worth confirming with the plan's tax advisor before retirement, rather than discovering it on the 1099-R.

A participant facing a policy in a money purchase plan generally has four paths:

1. Take the policy as an in-kind distribution. The participant receives the contract and includes its fair market value (less basis) in income, as described above. They then own the policy personally and keep the death benefit in force.

2. Buy the policy from the plan. The participant—or, in some cases, the employer or a trust—purchases the contract from the plan for cash equal to its fair market value. Because the plan receives full value, there is no taxable distribution of the policy itself. A sale of a policy by a plan to the insured participant is a prohibited transaction unless it fits within Prohibited Transaction Exemption 92-6, which permits the sale provided the plan is made whole. This "buy-out" or "swap-out" is often the cleanest exit when the participant wants to keep the coverage without triggering a large taxable distribution.

3. Surrender the policy inside the plan. The plan cashes out the contract and distributes (or retains) the proceeds. There's no fair market value puzzle—the participant simply takes a cash distribution like any other—but the insurance protection is lost.

4. Roll the cash, but not the policy. A frequently missed point: a life insurance contract cannot be rolled into an IRA. IRAs are prohibited from holding life insurance. The cash value can be surrendered and the resulting cash rolled over, but the policy itself cannot move to an IRA. If keeping the insurance matters, the in-kind distribution or buy-out is the only route, and a §1035 exchange into another policy or annuity is available only after the contract is in the participant's personal hands.

When the policy is distributed, the plan issues Form 1099-R reflecting the taxable amount—fair market value reduced by recoverable PS 58/Table 2001 basis. The carrier's Form 712 supports the valuation. Keep contemporaneous records of every year's reported PS 58/Table 2001 cost; without them, substantiating the basis offset later is difficult, and the participant may end up taxed on value they already paid tax on.

Distributing a life insurance policy from a money purchase plan is not complicated once you separate the two questions it raises. First, what is the policy worth?—answered by fair market value under the Rev. Proc. 2005-25 safe harbor, not by a convenient cash surrender value. Second, how much of that is taxable?—the fair market value reduced by previously taxed PS 58/Table 2001 costs and any after-tax basis.

Get the valuation from the carrier on Form 712, track the basis over the life of the policy, confirm whether the insured is treated as self-employed, and choose the exit—distribution, buy-out, surrender, or exchange—that fits the participant's goals. Handled deliberately, the policy leaves the plan at a defensible value and a predictable tax cost. Handled casually, it produces a surprise on the 1099-R that no one wants to explain after the fact.