How can small business owners selectively provide retirement benefits to key employees?
By Ken Davis
Many private business owners like to supplement retirement benefits for key employees through the use of life insurance purchases.
Business owners choose to provide employee benefits primarily to retain their best employees. Qualified plans are a good start to providing retirement benefits to employees. However, many private business owners like to supplement retirement benefits for key employees through the use of life insurance purchases.
This approach has the major advantage of allowing the employer to be selective in which key employees they choose to benefit and how much they choose to pay them. These plans allow them to customize the contributions paid to individual key employees and to exclude others without limit. They also allow the employer to design a custom vesting schedule to encourage the employee to continue working for them; what is referred to as a "golden handcuff." These types of plans are referred to as non-qualified plans and as such are not generally subject to the qualified plan rules. Administration and attendant costs are nominal in most cases.
This concept is commonly referred to as a 162 bonus plan. The employer has an employee obtain an individual life insurance policy on themselves which is designed to maximize cash value and minimize the life insurance element to the contract, thus maximizing cash value build up. The contributions to an employee’s individual life insurance policy by an employer are tax deductible as wages by the employer but taxable to the employee. In large part, these plans provide many of the tax benefits that a Roth retirement plan offers but with some substantial differences. There is no 10 percent penalty for early withdrawal and no forced distribution at age 70½. There are no IRS limits on contributions.
There is no deduction up front to the policy owner, the earnings are tax deferred and done properly, the distributions at retirement and at death are tax free. Opponents of these plans point to the high cost of insurance contracts and their limited growth. However, a policy can be designed to minimize insurance costs and maximize cash values, making them very competitive with other accumulation devices with similar risk profiles on an after-tax basis.
When structured properly, the net internal rate of return after all expenses may reach about 100 to 200 bps below the average gross crediting rate on the policy. Compare that with mutual fund expenses that, including trading costs, are said to average about 220 bps and have no life insurance. For example, if the client was fortunate to receive an average crediting rate of 7 percent with an indexed universal life policy, then they might see a 5.5 percent to 6 percent net IRR over time after-tax return. That result is obtained over many years. And in fact, the downside to life insurance as a cash accumulation device is predominantly the early withdrawal fees in the first 10 to 20 years and resultant low surrender cash values. And while the life insurance component costs money, the benefits can be used for both personal family protection and/or business purposes. Combine the economic cash accumulation with the life insurance benefit and the client could end up with a very nice end result. Retirement solutions for companies on limited budgets: Single IRC section 162 bonus plans
Let’s start the discussion with a couple definitions that will allow us to talk about this planning opportunity. Section 162 of the Internal Revenue Code is the section that allows employers to deduct employee compensation as a business expense. When an employer pays a premium to a life insurance company on a life insurance policy that is owned by an employee, the payment is considered compensation to the employee. As such, it is tax deductible by the company (as long as the total employee compensation is not deemed unreasonable under IRS rules) and is taxable as wages to the employee. It is reported to them on their W-2. We call this arrangement a single 162 bonus plan in our industry.
This arrangement is simple. The employee applies for a life insurance policy on their own life. Assuming they are approved, the employer pays the annual premiums on behalf of the employee as a bonus. The company gets a tax deduction for the payment and reports the income on the employee’s W-2. The income is considered wages and subject to all employment taxes as well.
The employee gets a cash value accumulation benefit and all the tax deferral and tax benefitted income that a cash value life policy provides, as well as a valuable life insurance benefit for their family. The down side is the tax cost to the employee without cash to pay the taxes. And the company does not recoup any of the premiums paid under this structure if the employee leaves.
Dealing with the tax cost of a single section 162 bonus to the employee; two solutions
The traditional way to deal with the tax cost associated with the premium payment has been for the employer to pay a second bonus as cash. And of course, the cash bonus is taxable as well, so the iterative calculation produces a need for an estimated second bonus of 70 percent. This assumes the employee has a combined federal and state income tax rate of about 40 percent. The employee gets the cash bonus and uses it to pay the taxes on both bonuses. This is called a double bonus 162 plan and the total of both bonuses are fully deductible by the employer, assuming they do not reach the threshold of “unreasonable compensation,” as defined by the tax law.
What is interesting about this situation is that the employer may get enough tax deduction so that the net cost is close to the bonus paid for the premium. So, simply ask the company how much net after tax savings they are willing to commit to the employee and then use that as the premium and the rest as cash. Of course, that is just a rough calculation and a tax advisor will need to be more precise by running a tax projection for them.
A newer solution is to have the employee borrow the tax cost from the cash value policy to pay the tax. The issue here is, aren’t we just moving chairs around on the Titanic? Does this really help the employee build wealth faster than splitting the bonus into a premium and cash bonus? Great question. Here is an alternative that might make this concept make sense. Some indexed universal life policies allow for an interest rate arbitrage that may add value to the wealth creation process and that provides more insurance as well with the higher premium. The policy allows the policyholder to borrow against the contract at a fixed interest rate. The insurance company then allows them to keep the collateral cash in the indexed strategy. If the credited indexed earnings are higher than the cost of the loan, then they make a positive interest rate spread or arbitrage.
This can be great if all goes well. But in years where the markets are down, the employee still has to pay the internal costs of the policy and the interest on the loan. And the loan costs could exceed the credited interest income in other years, even when the markets are up but not up enough. The employee should be very aware of this risk before accepting it. However, policies usually allow at least one move from the arbitrage type loan structure into a fixed account and collateral scheme. Some allow movement back and forth as desired.
In the early years, the employee may want to use the fixed accounts for part of the cash account allocation. As time goes by, they may want to take more risk and branch out even more if markets cooperate to help reduce the risk and use the strategy to pay taxes.
And yet another hybrid plan is to have the company pay the premium as compensation and then loan the tax cost to the employee. The employee will owe the company the premium plus interest at retirement. Given enough time and a reasonable rate of return, the employee takes an extra large loan the first year of retirement to pay back the company the loaned amounts.
This last approach has the advantage of reducing the annual tax bill since loans are not compensation. Further, the company could pay the loan off for the employee at retirement as a final bonus for loyalty. Of course, the payment of the loan through bonus means an additional taxable event to the employee. And the loans made to the employee are not tax deductible each year by the employer.
So, to summarize the options:
- Single bonus to employee in the form of premiums paid
- Double bonus to the employee to pay premium and cover tax with a cash bonus
- Single bonus with employee borrowing from policy to pay the tax
- Single up front bonus with employee taking loans from contract to pay the tax. Employer pays second large bonus later to repay contract loan.
- Single bonus coupled with employer loan of cash for taxes and repayment by employee to employer at a later date using cash values in the policy.
- Single bonus coupled with employer loan of cash for taxes but employer pays loan off for employee later as a final bonus
- The possibility of the employer paying off the accumulated loans acts as an incentive for the employee to remain as an employee.
The employer may want to retain the right to recover part of the premium payments in the event the employee does not stick around long enough. To do this, the employer has the employee sign a restrictive endorsement that is filed with the insurance company. The restriction blocks the employee from taking distributions or loans from the contract without the company’s signature. It also blocks them from using the cash value as collateral for an outside loan. Make sure you understand this as it is critical: the employer may not obtain or retain any ownership in the policy. The policy and all its rights are owned by the employee. The employer can block the use of the money but cannot take the money under any circumstances. This is important to avoid having these plans fall under adverse tax rules.
The only way the company has the right to unvested payments is through a separate employment agreement that states that if the employee leaves early, they must repay the unvested payments. The insurance policy does not act as collateral for non-payment of this debt. What transpires is that the employee has more cash in the policy than he or she owes to the company. So, the employee has the option to take a policy distribution to pay the employer but is not required to do so. After the employee pays back the unvested portion of the payments made on the policy, the employer releases the restrictive endorsement and they then can use the policy any way they choose to at that point. They would be foolish not to pay the debt to the company and lose access to the policy’s cash value going forward.
A very major benefit to the employee is that if the company files bankruptcy, then the restrictive endorsement is null and void. The employee owns the policy and, because the employer never had any ownership rights in the policy, the general creditors have no rights to use the policy for recovery of debt.
Another variation on the theme is a hybrid of the single and double bonus plans. For example, the employee agrees to take loans against the contract to pay the taxes, so this starts as a single bonus plan. Then if they stay for a period of time, the company agrees to pay the loans plus interest back plus enough additional cash bonus to pay the tax on the loan repayment amount. This could be used instead of the typical golden handcuff benefit, as the incentive to stay is now the second bonus instead of non-vested repayments. Maybe we call this one the golden carrot!
This last structure does pose a risk to the employee in that if the company goes bankrupt, they get the policy and any cash value but they lose out on the promised bonus to repay loans.
Regulatory Cautions It is imperative that our business clients employ an attorney and or CPA to oversee the legal and tax issues of these structures. The ERISA and Department of Labor laws could come to bear on this strategy if certain requirements are not met. I have resources written by insurance company advanced market attorneys that address these issues and how to comfortably avoid them. They even provide sample legal documents meant only for client attorneys.
The arrangement must be negotiated only with what is referred to as “top hat” employees: those that are highly compensated or meet ownership or executive status as defined in the law and regulations. The strategy must be employed on an employee by employee basis and not be part of a broader employee plan. It must be in writing. The company must not have any ownership rights in the contract. I will not go on, for that is for the lawyer and accountants to put into place and to advise the client on.
IRC section 162 bonuses are a great way to provide additional benefits to key employees:
- A structure similar to a Roth type qualified plan with less restrictions
- A way for the owner to keep a key employee loyal to the company with financial incentives to stay
- An option where payments are fully tax deductible to the company and the employee can cover the tax costs with an second cash bonus or various types of loan structures
- The employee may be able to benefit from an interest rate arbitrage
- Policy gains may be available to live on at retirement on a tax free basis as long as the policy remains in force until death
- The death benefit is available for the family of the employee
- The employee may partially benefit from positive market movements while being protected against market losses other than policy costs
- Complete employer flexibility in choosing which employees receive the benefits
- Complete flexibility in designing vesting schedules