An Employer/Employee Plan with Two Winners
It is not too often that a business can offer its employees a benefit that in the long run costs little or nothing. Split-dollar life insurance is a clever way to allow management to provide a key worker something of value knowing one day the company can recoup the costs. Sound too good to be true? It isn’t. This strategic arrangement brings a benefit to both employee and employer.
What is Split-Dollar Life Insurance?
The name is a little misleading. Split-dollar life insurance is not a policy, but rather an agreement between an employer and employee. A contract sets out the obligations and benefits of both parties as they pertain to a cash-value life insurance policy. The main issues addressed are who owns the policy, how much of the premium costs are paid by the employer (maybe all) and how the cash value and death benefit will be shared regardless when the employee dies.
Cash-value life insurance is a permanent policy where the premiums remain constant, and the policy never expires provided the insurer receives timely payments. A portion of the premiums are set aside giving the policy a “cash value” from which the insured can draw or borrow. These policies are normally five to fifteen times more expensive than term policies that have no cash value and eventually expire. Term insurance is usually set up to cover the insured for a span of ten to thirty years.
There are two main types of split-dollar life insurance contracts:
- Endorsement method: the employer owns and controls the permanent insurance policy, and it is written in the contract that the employee can name a beneficiary for a share of the death benefit. A clause is included for an exit strategy known as a “roll out”; i.e., how the contract will end at the employee’s retirement.
- Collateral assignment method: The employee owns and controls the permanent insurance policy. In this arrangement, it is spelled out that in the event of death the employee assigns a portion of the cash value and/or death benefit to the employer. Like the endorsement method, the employer pays most or all the premiums until retirement. However, since the policy is owned by the employee the employer’s portion of the premium payments are treated as loans. Since the employee owns the policy, he/she is free to do what he/she wishes at retirement after settling any cash value interest belonging to the employer.
Splitting Brings Togetherness
Cash-value life insurance is relatively expensive, and many employees will not buy it due to the cost. Would an employee take a policy if the employer paid a large portion or all the premiums? The answer is almost certainly yes. Offering such a benefit builds morale, helps retain employees and can even be used to attract new workers. The beauty of using cash-value insurance is that the employer retains an interest in the policy so it can tap into both the cash value and death benefit, up to the premiums paid. The employee benefits because he/she receives an insurance policy that otherwise may have been cost prohibitive. The employer enjoys the ability to provide a nice benefit knowing that one day it will recover the premiums paid.
Structuring a Split-Dollar Life Insurance Benefit
There really is no hard-and-fast rule on how a plan like this is executed. One of the beauties of these arrangements is that they are customizable based on the circumstances. The employer first needs to look at the goal of such a plan. Is the sole purpose to retain an employee? Maybe the employer wants to pay the full premium to deter an employee from leaving; an exit could be costly in losing a good policy or having to take on high payments. If the employer just wants to offer life insurance protection as part of a benefits package, then it’s possible that the employee would pay a portion of the premium. Here the employee gets a good policy which otherwise may have been unaffordable.
The split-dollar agreement normally ends at retirement, and it is then that the employer recovers the premiums paid from the policy’s cash value. If the employee owns the policy, he/she could elect to continue the policy by taking on responsibility for future premiums. In the event employer owns the policy, the employer could take its share of the cash value portion or “bonus” it to the employee. The employer could also keep the policy in place and collect a tax-free benefit when the retired employee dies.
Protecting Against the Loss of a Key Employee
Many companies would suffer a financial if their key employees died. Finding a skilled replacement, training someone new, and the loss of productivity are all costs that can be associated with losing certain key people. Some losses can be so great that is prudent to protect against them. If a company can quantify what the losses would be, those predicted costs could be built into a split-dollar life insurance contract. If the employee dies before retirement, the employer will recover those losses and the premiums paid, while the balance of any cash value and death benefit would go to the employee’s beneficiary.
Companies have learned that using a split-dollar insurance policy can be a creative way to retain a key employee. Imagine a policy that is structured to have a $1,000,000 death benefit and a cash-value of $200,000 in fifteen years. There is a nice incentive for an employee to stay, knowing that he/she will one day have access to borrow from, annuitize, or use as a tax diversified retirement supplement. This “golden handcuff” approach provides a valuable fringe benefit to the employee at all times while providing the employer with complete cost recovery.
Tax Implications
In 2003, the IRS tightened regulations relating to split-dollar life insurance agreements. Policy ownership is critical in determining if employer-premium payments are classified as a non-deductible expense or a loan to the employee. There are many moving parts contained within these agreements which is why both a lawyer and CPA need to be involved in its execution.
Registered Representative, Securities offered through Cambridge Investment Research Inc., a Broker/Dealer, Member FINRA/SIPC. Investment Advisor Representative. Cambridge Investment Research Advisors Inc., a Registered Investment Advisor. New South Wealth Management and Cambridge are not affiliated.