What is an Executive Bonus Plan, also known as an IRS Section 162 Plan?
A section 162 executive bonus plan provides a way to give executives within a businesses or corporation additional benefits, typically funded with life insurance, as a way to further incentivize specific executives individually chosen by the company. (1)
A typical executive bonus plan design requires the employer to pay the life insurance premium and include the premium in the employee’s taxable wages.
A section 162 executive bonus plan is a form of business continuation and succession planning vital to the ongoing operation of a business.
Normally, the employee is the owner of the policy and has all the policy’s rights typically inherent as the owner of a policy. The employee (the insured) determines the life insurance beneficiary and the employee has access to the policy funds.
An executive bonus plan using cash value life insurance to provide an additional benefit to your key employees is a great method for retaining your top talent.
The employer of the executive bonus plan can cover the cost of the policy (the premiums) through periodic bonuses to the employee, which the employee in turn uses to pay the policy premiums to the insurance company.
The employer bonus payments to the employee are tax deductible under Internal Revenue Code Section 162 for the bonus amount, within the limits of reasonable compensation.(2)
Upon retirement, or some other mutually agreed upon date between the employer and employee, the employee can access the policy’s cash value through withdrawals or borrow against the cash value via policy loans to use as an additional income source, such as supplemental retirement income.
One benefit is the employee would not be taxed on much of the cash value since the premiums have already been taxed. In fact, the employee’s tax basis would equal the sum of the paid premiums.
Finally, upon the death of the employee, the death benefit would go to the employee’s named beneficiaries.
There are many pros to using life insurance as part of an executive bonus plan, as well as a few disadvantages.
AND using whole life insurance from a mutual insurance company for this strategy as opposed to other types of life insurance such as universal life or term life insurance offer some additional incentives for your key people.
5 Pros to Using Cash Value Life Insurance in an Executive Bonus Plan
- Customizable Employee Bonus Plan: the employer can add certain incentives to the plan in order to retain the employee and/or require the employee to reach certain performance benchmarks.
- Employer Selects Key Employees: Executive bonus plans are nonqualified plans, which allows the employer to choose which employee(s) to offer the plan to, instead of providing the benefit to the entire work force.
- Employer’s Income Tax Deduction: The employer receives a tax deduction for the premiums paid into the employee’s policy.
- Simple to Set Up and Implement: The major step is to have the Key Employee qualify for life insurance coverage.
- Employee Uses Accrued Cash Value to Supplement Retirement Income: the employee would not be taxed on the cash value up to the basis since the premiums have already been taxed.
Cons to Using Life Insurance in an Executive Bonus Plan
- Portability: Depending on your vantage point, the portability of the policy may be a pro or con of using life insurance in an executive business plan. When the employee leaves, the life insurance policy goes with the employee. The employer can cease making payments but the valuable employee, and his or her policy, has left the company. Of course, the portability of the policy is a positive for the employee.
- Taxable as income: Another potential drawback is the bonus is considered employee income and would be subject to income tax. However, under a “double bonus” plan that is not a concern since the employer pays an additional bonus to the employee to cover taxes.
How to Structure the Executive Bonus Plan
The most advantageous set up for the employee is to design the section 162 executive bonus plan with a “double bonus.”
An executive bonus plan is taxable to the employee. So a way to compensate the employee is to utilize a double bonus, which pays the executive bonus for the life insurance policy’s periodic premium payment, as well as an additional bonus that covers income taxes owed.
Another advantage for the business owner or company is that if the employer desires to use the Executive Bonus Plan as an incentive, the employee’s access to the policy’s cash value can be restricted until a predetermined date.
Often, this is done through a quasi “vesting” type arrangement, which works in favor of the employer retaining the employee, since the employee is now incentivized to continue with the company into the future. That is why executive bonus plans are often synonymous with key person insurance.
Still another advantage is that the employer can design the bonus plan to reward performance by setting ascertainable goals. Failure by the employee to reach these goals may decrease or eliminate the bonus.
Why Cash Value Life Insurance Is Best When Funding An Executive Bonus Plan
There are two main types of life insurance: term life and permanent life. Within those two main categories are various other types of policies designed to work in various ways which include universal life and traditional ordinary whole life policies.
When considering how to fund an executive bonus plan, several factors should be considered. For example, consider the following life insurance options:
Term Life Insurance:
Term life insurance is a great short term option to replace lost income or to cover a mortgage. It even has a few benefits as key person life insurance if a simple death benefit is the goal. However, an executive bonus plan’s key components is the cash value incentive for the employee, so term life is typically not a good choice.
Irrevocable Life Insurance Trust (ILIT)
One exception to the unfavorability of term life insurance for executive bonus plans if is the employee has accumulated a large estate and it is advantageous to use the policy to fund an irrevocable life insurance trust.
The main advantage here is that the proceeds from the death benefit would not be included in the employee’s taxable estate since the death benefit would pay out to the ILIT, thus avoiding exposure to the federal death tax. Because cash value life insurance offers minimal benefits when held in an ILIT, a term life policy may have some value for this limited strategy.
However, overall, permanent life insurance is superior to term life when designing a section 162 executive bonus plan. Term life has no cash value and it ends upon expiration of the term and becomes cost prohibitive down the road. It generally does not provide an incentive to key executives.
Universal Life Insurance:
Many advisors prefer either guaranteed universal life or indexed universal life (IULs) due to the flexibility inherent in these types of policies. Admittedly, these are hot products that offer an enticing rate of return because they are tied to any one or more of a number of market indexes that may offer a higher rate of return.
Essentially, IULs are an attempt to offer the policy holder an opportunity to take advantage of market upsides in the same way as other financial products such as mutual funds, while limiting the downside.
One benefit to using an IUL for an executive bonus plan is that they offer the employer the ability to change premium payments, which helps with creating incentives for the employee. However, flexible premiums may be the only upside for this strategy.
Because IULs may offer a higher potential upside rate of return, they do not offer the same kinds of guarantees concerning ongoing cash accumulation (supplemented by a strong history of dividends) as that offered by traditional whole life insurance.
Also, costs are more speculative with IUL policies as they are deducted from the policy’s cash value, and all of this adds to the volatility of IUL policies.
Thus, it is possible for the cash value to decline or even disappear during less favorable market cycles due to cost depletion. Your company doesn’t want to have to explain to a key employee (upon vesting of the policy) why a policy has little cash value despite premiums being paid.
For all of the above reasons, our opinion is that IULs are not typically as favorable for executive bonus plans as traditional cash value whole life insurance.
Whole Life Insurance:
At Insurance & Estate Strategies, when we talk about whole life or cash value life insurance ,we are talking about whole life insurance from a top rated mutual company.
Our preferred companies offer favorable terms for borrowing cash from the policy while offering an ongoing guaranteed rate of return, guaranteed premiums, and guaranteed cash accumulation.
Many whole life insurance companies also pay a tax free dividend that is essentially a return of premiums to the policy owners (who are also the owners of a mutual insurance company).
This specific type of whole life insurance offers substantial benefits to key people due to the steady accumulation of cash value within the policy and the flexible access to cash, as well as favorable tax treatment. The employee-policy owner therefore gets the use of the cash value and thus can take advantage of the benefits offered by infinite banking. Thus, this type of specially designed whole life insurance is an ideal option for an executive bonus plan.
If you have made the decision that an executive bonus plan funded with life insurance is the right choice for you, or if you would like to talk it over with a seasoned professional, please give us a call today. We work with a number of top life insurance companies and can do a side by side comparison. Our job is to align your key employee with the best company that is focused on maximizing the benefits to your company and employees.
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