What is split-dollar life insurance?
Split-dollar life insurance isn’t a specific insurance product, like whole or term life insurance. Rather, it’s a strategy for using permanent life insurance to benefit two parties – typically an employer and a high-level employee. This article will help you understand:
- How the plans work
- Benefits for companies and employees
- Legal considerations1
Each split dollar life insurance plan is a unique entity defined by a contract between the parties. Each side agrees to share ownership of a permanent cash-value life insurance policy and jointly decide how to split the policy’s cash value, premium costs, and death benefit. Split dollar life insurance agreements are most commonly offered as an incentive to recruit high-level executives or highly talented individuals. Split-dollar plans differ from traditional permanent life insurance plans because ownership of the policy determines who can legally tap into the policy's cash value and how the premiums are taxed.2 Generally, split-dollar plans identify the following elements:
- Who owns the policy?
- assigns responsibility for the premiums and;
- explains the division of benefits and the policy’s cash value
These insurance plans also commonly note employees' work responsibilities, the period of coverage for the plan, and outlines scenarios that lead to termination. For example, if the employee quits or fails to perform their job satisfactorily. Though, split dollar life insurance plans usually end when the employee dies or on a specific future date.
What are the benefits?
Split-dollar life insurance agreements can be mutually beneficial, with employees and employers reaping financial gains. Specifically, employers benefit from the structure of the policies, which allow them to choose the recipient of the plan, the amount of the benefit, and when the benefit is given. Additionally, split-dollar life insurance plans are not subject to the rules and restrictions commonly found in traditional life insurance policies. Finally, these plans can be economically advantageous given their relatively low start-up costs and also allow companies to recoup their investment when an employee leaves or passes away.
Employees can benefit from split-dollar life insurance plans as well. For starters, employers are responsible for making the premiums. Another critical benefit is that employees have the freedom to create a policy that meets their specific needs. Additionally, they may be able to make tax-efficient withdrawals or loans from their plans, increasing income during retirement. Finally, employees may take advantage of the tax-deferred growth of split-dollar plan's cash values.
Although split-dollar plans have existed for some time, regulatory changes have added restrictions to what some already viewed as a complex life insurance option. Specifically, in 2003 the IRS issued updated guidance regarding the types of split-dollar agreements that may be formed. The revised regulation states that only economic benefit and loan arrangements may be created. While this updated regulation prohibits all other split-dollar life insurance arrangements, it still allows certain benefits. For instance, employers retain the right to use corporate dollars to pay for personal life insurance plans, employees can customize plans to help minimize future gift and estate taxes, and ensure interest rate increases don't impact future loans. Instead, employees in a loan arrangement are locked into the interest rate in place when the plan was signed.
A central component of split-dollar life insurance plans that sets them apart from traditional employer-sponsored group life insurance is that they don't have the same standard insurance language. Instead, they are highly customizable and can be designed to meet all parties' needs. Before entering into a split-dollar agreement, employers and employees are advised to consult financial and legal professionals to ensure that both parties' interests are reflected in the agreement.
Split-dollar insurance plans:
The two most common forms of split-dollar life insurance are economic benefit and loan arrangements. In an economic benefit arrangement, the employer owns the policy, covers the premiums, and has the authority to grant the rights and benefits. For example, an employer may permit the employee to name their beneficiaries, ensuring that the employee control who receives their death benefits. It's important to note that under this option, when an employee leaves the company, they may be able to purchase the plan or have the ownership transferred to them.
In contrast, loan arrangements allow employee ownership of the policy, but the employer makes the premiums. Under this arrangement, the employers' premium payments are treated as a loan to the employee. In turn, the employee must make payments to the employer to protect their interest (aka ownership) in the policy. This transactional agreement is known as a collateral assignment. Collateral assignments restrict employees' rights, limiting their ability to modify the split-dollar policy without permission. They frequently allow employers to recover any funds loaned to the employee if the agreement is terminated or the employee dies.
Further adding to the many layers of this arrangement, every year, premium payments create a new loan. Although each year creates a new loan, they can be structured as term or demand and are required to have reasonable interest rates (per the applicable federal rate). Employees may benefit from the fact that loan interest rates can be below current rates, but this largely depends on how the contract is written and its duration.
Finally, split-dollar life insurance isn't just for employers and employees. Private citizens can also access this tool, which can be particularly useful when conducting high-value estate planning. Wealthy people can create private split-dollar life insurance agreements, which can help reduce estate taxes. This could be an option to explore if you have significant wealth you want to protect for future generations. A financial professional can provide critical information to help inform your decision.
Frequently asked questions about split-dollar life insurance
What is a split-dollar life insurance plan?
A split-dollar life insurance plan is an agreement between an employer and an employee in which they hold joint ownership of a permanent cash-value life insurance policy, including its benefits and premiums.
What is the benefit of split-dollar life insurance?
A. Split-dollar life insurance can be a mutually beneficial arrangement for employers and employees, with each party gaining different advantages. For example, employees receive quality life insurance for little cost and may be able to access tax-efficient income through withdrawals or loans. In turn, employers can attract and retain top-level talent, knowing they can ultimately receive a guaranteed return on their investment when the agreement ends.3
Who pays the premiums in a split-dollar plan?
A. Employers are responsible for making split-dollar life insurance premiums, regardless of the plan's type. However, it is important to note that under loan arrangements, employees must repay the premiums via collateral assignments made to their employer.