Split-Dollar Life Insurance Plans: How Do They Work?
Typically, your beneficiary is a person.
Businesses can usually be beneficiaries, too.
A life insurance policy pays out to the beneficiaries when you die. This allows them to have funds to continue living life as usual.
If the beneficiary is a business, the funds can help the company continue running while the succession plan is executed.
There are several types of life insurance policies to consider. These often include term life insurance and many kinds of permanent life insurance.
There are also unique ways you can structure policies.
If you’re a highly compensated employee at a business, you may get different benefits than a standard employee. These benefits exist to keep or retain high-level employees.
Some of these employees may get offered a rarer benefit called split-dollar life insurance. Here are the basics to help give you an idea of what a split-dollar plan is.
What is Split-Dollar Life Insurance?
In reality, there isn’t a particular type of insurance called split-dollar life insurance. Life insurance companies don’t sell it.
Instead, it’s more of an agreement between two parties.
A better name would be split-dollar life insurance arrangements. These arrangements are usually an employee benefit. They may be offered to key employees in a company, such as CEOs.
Essentially, these arrangements have the employee and the employer split the cost and benefit of a permanent life insurance policy.
The employee and employer must decide which entity owns the policy, pays the premiums and how the benefits get split.
Depending on these decisions, the policy may be treated in different ways for tax purposes.
These plans used to be more popular because they offered tax beneficial treatment. Unfortunately, the IRS made changes in the early 2000s. These changes substantially altered the tax impacts.
This made split-dollar life insurance arrangements much less tax advantageous and less popular.
When putting a split-dollar life insurance policy into place, all involved parties should sign an agreement.
The agreement should state exactly how the policy will work and who handles each part. This way, everyone is clear on the specifics of the situation.
How Split-Dollar Life Insurance Works
Under the current tax situation, there are two main ways a split-dollar life insurance policy could work. These are based on the tax impacts defined by the IRS.
These are the two methods the IRS has specified in their most recent guidance.
Economic Benefit Arrangement
The economic benefit arrangement requires your employer to own the policy.
You receive the benefits, though. The employer usually pays the premiums.
In this case, you’ll be taxed on the value of the life insurance you receive.
You can’t pick any amount you want to assign. Either the IRS or insurance company will determine how much value you receive.
You then owe tax on that value.
This other potential classification is used when an employee owns the policy but the employer makes premium payments.
The loan arrangement is commonly known as a collateral assignment. It’s called this because you assign some of the collateral, or benefits, to your employer as part of the policy.
The IRS uses the concept called loan regime to govern the taxability of these plans. Basically, you’re receiving a loan in the amount of the premiums paid by your employer.
You’ll owe tax on the calculated interest on the loan.
Check with your employer to see what interest rate is used in your agreement. Then, your tax advisor can help you figure how much tax you’ll owe.
When you die, the death benefit is used to repay the loan. Any remaining death benefit passes on to your beneficiaries.
If the loan for the premiums paid is forgiven at any time, the employee will owe income tax on the forgiven amount. This can be a hefty tax bill.
Estate Planning Aspects of Split-Dollar Life Insurance
Split-dollar life insurance doesn’t have to be between a business and an employee, though.
For high net worth individuals, it can be used as an estate planning tool.
This usually involves a person putting a permanent life insurance policy into an irrevocable life insurance trust (ILIT).
Once in the trust, you don’t have control over the policy. If done correctly, the idea is the policy won’t be included as part of your estate and can therefore avoid the estate tax.
This is only for high net worth individuals because the average person won’t be subject to the estate tax.
It only impacts you if you use your entire $11,580,000 estate and gift tax exemption. Most people come nowhere near this.
This tax planning concept is complex. It requires specific planning based on your situation.
Make sure to consult the applicable experts. They can let you know if this will work for you and how to enact it.
Terminating Split-Dollar Life Insurance Plans
Terminating split-dollar life insurance plans can be complicated.
Often, the contract signed to enact the split-dollar plan will state what will happen and when.
These policies may terminate on a specific date. This date may match up with a retirement date.
In other cases, the policy may get transferred to the employee once the conditions of the contract were completed.
Policies also end if you unexpectedly die. Read the terms of your contract to see what happens in this case.
Due to the complexity of permanent life insurance and the cash value component, there may be taxable impacts. Consult your tax professional and agreement for details about termination.
When Split-Dollar Life Insurance Might Make Sense
Split-dollar life insurance could be worth looking into in a couple of key situations.
First, it may be a great way to get extra compensation as a highly compensated employee.
If you expect to be one of the top paid people in your organization, consider asking about it as an employee benefit.
Split-dollar life insurance may be something to look into personally if you expect to exceed the lifetime estate and gift tax exemption.
It could be an option to lower your estate’s tax burden if it works for your situation and is implemented correctly.
When Split-Dollar Life Insurance Doesn’t Make Sense
Split-dollar life insurance doesn’t make much sense for the ordinary person.
If you aren’t in the C-suite or other top-level positions in your organization, you probably won’t be able to negotiate this benefit from an employer.
From an estate planning perspective, it doesn’t make much sense for everyday people, either. It merely makes life insurance more complex with no real benefits.
The key is staying under the lifetime estate and gift tax exemption. This won’t be a problem for the vast majority of households.
Alternatives to Split-Dollar Life Insurance
If split-dollar life insurance sounds too complex for your situation, you have many other options to consider.
Term life insurance
First, you could buy a standard term life insurance policy. These policies are often the cheapest available option and provide the coverage most families need.
They are only in effect for the term you purchase. If you don’t die before the term expires, you receive nothing.
This is why this type of insurance is so much cheaper.
Ideally, you’ll build assets during the term. If you do, you may no longer need life insurance after the term expires.
Permanent life insurance
In some cases, people may feel more comfortable with permanent life insurance. This is the same type of policy used in split-dollar life insurance arrangements.
The difference is you’ll own the entire policy. There will be no arrangement with an employer or trust.
These policies cost more because they are permanent.
As long as you keep the policy in effect and follow the rules, your beneficiaries will get the death benefit when you die.
Because the policy is guaranteed to be paid out, insurance companies need to charge more to be able to pay out the death benefit.
Additionally, there may be cash value components that add extra costs to the policies.
Split-dollar life insurance and its tax impacts are complicated. It may seem like a good idea to share the costs, but it depends on your situation.
In the end, it may be so complex it isn’t worth the effort for most people. Even so, it could have a place in your financial planning strategy.
Many highly paid or high net worth individuals already hire tax professionals. Adding another complexity may not be a big deal.
Before entering into one of these arrangements, consult a professional. In particular, you may want to speak with a tax professional and potentially a fee-only fiduciary financial advisor.
These professionals should be able to show you how these policies could impact your situation, including eventual estate taxes.