If you own a business, using a split dollar life insurance plan can help you shift business income to you on a tax effective basis, without involving other employees!
Split dollar life insurance refers to the concept of two or more parties splitting the benefits and costs of a life insurance policy, such as the premium, death benefit and cash value.
The most common type of split dollar life arrangement involves an employer and the employee or owners, with one part owning the policy, one or both parties’ contribution to the annual premium, but both parties having a vested interest in the policy benefits.
Split dollar plans are inexpensive and easy to administer as an executive benefit arrangement.
Here is how it works:
One party establishes a cash value life insurance contract under the ownership of the key executive.
The employer receives a “collateral assignment” against the policy, entitling the corporation to receive the lesser of the policy cash value or the outstanding loan balance. The loan is based on the premiums contributed by the company. The same assignment entitles the employer to a portion of the policy death benefit, equal to the outstanding loan balance.
The key executive pays the taxes each year on the foregone interest on the loan from the corporation to pay the premium.
At some point in the future, the split dollar arrangement terminates when the employer’s loan is repaid (typically from the policies cash value), leaving the executive “free and clear” ownership of the accumulated gain in the life insurance policy.
The executive can access the accumulated gains in the policy by borrowing against it, which will typically allow for tax-free access to the values. The policy loan is repaid to the insurance company at the death of the executive, and any residual death benefit is paid to the executives’ named beneficiaries.
Split dollar is an easier benefit to implement than deferred compensation, and less expensive for the employer.
- Easy account entries
- Recovery of the cost for the employer
- Performance objectives to trigger the funding for employer
- Very little if any impact on company balance sheet
- A “golden handcuffs” for the employer and ability to set restrictions when cash value can be accessed
Today’s newer types of life insurance policies enhance the benefits of a split dollar plan!
By using an index life insurance policy where the returns are linked to the stock market index, the difference between the rate of return on the policy cash value compared to the tax paid on interest for the premium loan, creates arbitraging, and the ability to create a future cash cow. The policy if designed properly can create a tax-free family bank.
Let’s say the “applicable federal rate is approximately 2%. This is the rate that is applied to the premium loans under the split dollar life insurance plan. The executive’s “tax-cost” would be 25%-35%. The employee’s costs would be from .50% to .70 of 1%. Image the difference when the policy returns on the cash value are receiving 5-10%. Overtime, the arbitraging creates a substantial gain and growth for the executive.
Walking into retirement with a boat load of money:
At retirement the company is paid back its premium cost via loans in the policy. The executive takes over the policy and retains the excess cash value of the policy. This is particularly valuable if the policy premiums are suspended after the termination of the split dollar agreement, and the employer has been paid back through policy loans. The executive keeps the net death benefit, and cash value. Death benefits are tax-free. The executive can take more policy benefit via tax-free loans to fund certain retirement needs. Again, I use the term “family bank”, A SELF EXPLAINED TERM.
For small business owners, where the cash flow is strong, Split Dollar can create future wealth using the corporate cash flow, and an effective tax efficient executive benefit. This type of benefit is great for the owner of a company, as they can use corporate dollars to transfer to the owner on a tax effective basis. That means that the owner does not have to involve all the employees like other retirement and health benefit. It can also be used to retain key people, especially when used with a vesting schedule.