What’s Split-Dollar Life Insurance? Pros, Cons & How It Works

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It’s getting more difficult each year for employers to retain high-value employees. With so many baby boomers now retiring, the competition is fierce for capable individuals to fill the growing number of job openings. Employers have to offer competitive compensation packages, including life insurance and retirement benefits.

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As new tax law changes continue to be enacted, the employee benefits options for employers are dwindling. One of the benefits still available is the split-dollar life insurance plan. It’s a non-qualified plan that can be a valuable tool for employers that want to provide additional benefits for key employees, to reward and retain them.

A non-qualified plan is a type of retirement plan that an employer sponsors, and it’s tax-deferred. The reason a split-dollar life insurance plan is non-qualified is that it falls outside the Employee Retirement Income Security Act (ERISA) guidelines, and it’s exempt from the testing required for qualified retirement plans.

What is Split-Dollar Life Insurance?

The majority of split-dollar life insurance plans are used in business settings, and the two participants are typically an employer and an employee/executive. However, plans may also be set up between individuals (known as “private split-dollar plans) or utilizing an estate planning tool called an irrevocable life insurance trust (ILIT).

For this article's purposes, we’re going to primarily discuss arrangements between employees and employers; however, many of the rules addressed are similar for all plans.

In a split-dollar plan, an employee and employer sign a written agreement that outlines how the premium cost will be shared, as well as the cash value and death benefit of a permanent life insurance policy. The contract details what the employee must accomplish, how long the plan stays in effect, and how the split-dollar plan will be terminated.

It also contains essential provisions restricting or ending benefits if the employee doesn’t achieve performance metrics that have been agreed upon or decides to terminate their employment.

Since split-dollar life insurance plans aren’t subject to any ERISA rules, there’s a lot of latitude in how the agreement can be written. Even with this latitude, all contracts must adhere to specific legal and tax requirements. A qualified tax advisor or attorney should be consulted when the legal documents are drawn up.

Split-dollar life insurance plans also require detailed record-keeping and annual tax reporting. Generally, the owner of the policy is also the owner for tax purposes. There are limits on the usefulness of split-dollar plans that depend on how the business is structured (S-Corporation, C-Corporation, etc.) and whether or not plan participants also share in the company's ownership.

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How Does Split-Dollar Life Insurance Work?

As alluded to earlier, the legal agreement is at the heart of a split-dollar plan since it covers all aspects of cash benefits, premium payments, and death benefit payout. The agreement is legally binding for both parties and should comply with all tax laws and regulations at the local, state, and federal levels.

Among other considerations, every agreement will include:

  • The total cost of the life insurance premium and the portion the employee and employer each agree to pay.
  • Who is entitled to the cash value of the policy and its death benefit
  • The conditions the employee must satisfy to remain eligible for the split-dollar plan, such as attendance requirements and performance objectives
  • When the plan takes effect and how long it will last
  • How the plan may be changed or terminated

When the terms of a split-dollar life insurance plan involve an employee/employer relationship, the agreement's conditions and provisions provide for what happens at the termination of employment.

The split-dollar plan should be considered an employee benefit. Like all benefit plans, the employer is unlikely to continue sharing the cost of a life insurance policy after an individual’s employment has ended, regardless of whether it was voluntary or not. 

With some plans, the employee can maintain the plan at their cost, but that will depend on the policy's insurance provider and terms.

Outside of the termination of an employee, split-dollar plans are terminated at a future date specified in the agreement or on the employee’s death.

At the premature death of an employee, depending on the written agreement, the employer will recover either the cash value, the premiums paid, or the amount the employee accessed through loan provisions of the policy and agreement. Once repayment is made, all restrictions on the policy or its named beneficiaries are released. The employee’s designated beneficiaries, which can be a trust, receive the remainder as a tax-free death benefit.

If the employee fulfills all of the requirements and terms of the agreement, all restrictions are released under the loan agreement, and ownership is transferred to the employee under what is known as “the economic benefit arrangement.”

Depending upon how the agreement was drafted, the employer can recover a portion of or all of the cash value or premiums paid. After this is completed, the employee owns the life insurance policy. The policy’s value is taxed to the employee as regular compensation and is tax-deductible for the employer.

What Are the Pros and Cons of Split-Dollar Life Insurance?

There are more advantages than disadvantages to split-dollar life insurance. Depending on the type of agreement, the benefits can include:

  • Low-cost life insurance: Sharing the life insurance cost gives the employee and employer a low-cost option for life insurance.
  • Avoidance of insurability issues: The insured employee can be protected from future insurability problems if they get sick or injured while they’re on the plan.
  • Future premium savings: The employee can have a lower cost on future life insurance policies when they maintain a policy. Premiums are based on the age they were when they originally applied for the life insurance, not the age when they terminate employment or retire.
  • Access to cash: If allowed in the plan agreement, the employee can access the cash value or borrow from the policy.
  • Tax benefits: Split-dollar life insurance plans can minimize estate and gift taxes and provide other potential tax benefits, which will depend on how the plan was written.

Split-dollar life insurance plans do have two negative aspects:

  • Confusion: Split-dollar plans, because of the flexibility and many different options, can be confusing to employers and employees.
  • Tax calculations: Calculating the tax ramifications to the employer and employee usually requires the services of a Certified Public Accountant (CPA), which can be time-consuming.

What Are Popular Alternatives to Split-Dollar Life Insurance?

The alternatives to split-dollar life insurance plans are somewhat limited. Let’s look at three non-qualified plan alternatives:

  • Deferred-compensation plans
  • Executive bonus plans
  • Group carve-out plans

Many employers consider and evaluate these three alternatives and compare them to a split-dollar life insurance plan when considering split-dollar. Potential tax treatment for the employer and employee is often a significant factor in the plan the employer selects, and some companies offer more than one of these plans to their employees.

Bear in mind that the purpose of any non-qualified plan is to both reward and retain key employees of a company. 

Deferred compensation plans

There are two types of deferred compensation plans: salary-continuation plans and true deferred compensation plans. Both of these types of plans are designed to reward employees with supplemental retirement income. The major difference between the two is the funding source. With a true deferred compensation plan, the executive defers part of their income, which is often bonus income.

With a salary-continuation plan, the company funds the future retirement benefit on behalf of the executive. Both types of plans allow the executive’s earnings to accumulate on a tax-deferred basis, meaning the Internal Revenue Service (IRS) taxes the income received at retirement at ordinary income rates.

Executive bonus plans

These plans are very straightforward. The employer issues the executive a life insurance policy with the premiums paid by the employer as a bonus. Premium payments are made by the employer and are tax-deductible because they are considered compensation. The bonus payments (premiums paid) are taxable to the executive.

In some cases, the employer pays an additional bonus above the premium amount to compensate the executive for the taxes they pay.

Group carve-out plans

Group carve-out plans are another type of life insurance arrangement. The company carves out a key employee’s group life insurance over $50,000 and replaces it with an individual life insurance policy.

As a result, the employee avoids the imputed group income on the group life plan that exceeds $50,000. The employer redirects the premium it would have paid on the excess group life insurance to the employee's individual life insurance policy.

The Difference Between Qualified and Non-Qualified Plans

In this article, we’ve looked at different types of non-qualified plans, which are sometimes confused with qualified plans. Let’s look at the differences between the two.

Qualified plans

Qualified plans include 401(k) plans, 403(b) plans, profit-sharing plans, and Keogh (HR-10) plans. These plans are designed to meet the Employee Retirement Income Security Act (ERISA) guidelines. As a result, they qualify for additional tax benefits from those received by other types of retirement plans, such as IRAs. Qualified plan sponsors have to meet numerous guidelines, including:

  • Participation
  • Vesting
  • Funding
  • Benefit accrual
  • Plan information

These are all needed to qualify their plans under ERISA.

Non-qualified retirement plans

Non-qualified retirement plans, including split-dollar life insurance plans, executive bonus plans, and deferred compensation plans, are offered by employers as part of an executive or benefits package. These plans aren’t eligible for tax-deferred benefits under ERISA.

As a result, deducted contributions for non-qualified plans are taxed when the income is realized. In other words, the executive or employee pays taxes on the funds before they’re contributed to the plan.

A couple of side notes: ERISA was enacted in 1974 to protect workers’ retirement income and provide a measure of transparency and information. Also, IRAs are not created by employers and, as a result, aren’t considered qualified plans.

Take a Team Approach to Split-Dollar Life Insurance Plans

As you can see, split-dollar life insurance plans can be quite complex. They should always be written and reviewed by a qualified professional, like an attorney, to be sure they meet all legal requirements and protect both the employer’s and employee’s best interests. 

It’s advisable to seek the advice of a tax attorney, CPA, licensed life insurance agent, and/or a certified financial planner (CFP) to design the plan and determine its implications for both the employer and employee.

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