What Is Split-Dollar Life Insurance and How Does It Work?
Like the best life insurance, a split-dollar life insurance plan offers protection against a life lost. Specifically, it’s an arrangement by which if an especially important employee within a company were to die, both the employer and the employee’s beneficiaries could benefit.
If you're the employer, split-dollar life insurance provides an option to offer an extra policy — above any regular coverage you may be offering the rest of your workforce — that covers a high-value employee, such as your CEO.
The death benefit from the arrangement is, as its name implies, typically split between employer and employee.
Here’s a rundown of the benefits, tax advantages and costs of a split-dollar life insurance plan for your business. The result is a guide that can help you decide whether such an arrangement is right for you and your business.
What is a split-dollar life insurance plan?
Excepting plans set up by individuals, split-dollar life insurance is an agreement in which the benefits from a policy for which the employer (usually) pays is divided between the company and the employee. The coverage is taken out on high-value workers whose death could deliver a significant financial blow to the company.
As well as being a financial cushion for the company against the death of an especially important employee, split-dollar plans provide the employer with a benefit that can be used in future to attract and retain valuable talent. There’s often even a tax break on the money used to fund the policy.
For the high-level employees they cover, split-dollar plans enrich their compensation package with a welcome fringe benefit. A plan can also aid in estate planning, by creating an investment vehicle within the policy whose earnings are sheltered from tax.
While usually associated with employer and employee agreements, citizens can also create split-dollar life insurance agreements. Such plans can help high-worth individuals reduce estate taxes, and so maximize what they pass along to future generations.
How does split-dollar life insurance work?
The employer typically initiates a split-dollar life insurance plan, after consultation with the employee who is to be covered. The company and designated worker agree on the division of costs and the death benefit. Employers often cover the entire cost of the policy, while the proceeds in the event of death are divided between the company and the beneficiaries the employee has designated.
Split-dollar insurance arrangements typically feature a whole-life insurance policy (which requires understanding how term vs. whole life insurance compare). Such policies provide permanent coverage, the type of life insurance that both delivers a death benefit and accumulates a cash value. This cash value grows over time from premiums paid into the plan, along with interest on that sum.
The agreement on a split-dollar plan, then, includes not only how premiums are paid and the death benefit is divided, but on the conditions under which the employee might be able to access the policy’s cash value.
In short, this life insurance vehicle is not a policy. Instead, it's more of a formal contractual agreement between employer and employee that details how to handle a life insurance policy's premium payments, tax benefits and ownership rights.
Don’t attempt to set up a split-dollar plan by yourself, especially if you're still mastering life insurance for beginners, A professional with financial planning and tax expertise can advise on setting up such an arrangement.
Premium payment structure
In most cases, the employer takes responsibility for paying the premiums for the insured employee. It's not unknown, though, for the employer and employee to share in these costs.
The split-dollar life insurance agreement will clearly outline whether the premium payments are divided equally or lean toward one or the other of the parties.
Life insurance policy ownership and beneficiary designation
Creating a split-dollar life insurance arrangement requires agreement on which party will own the policy and which will be designated as a beneficiary, in full or in part. These types of policies are available as either employer-owned or employee-owned.
- Employer-owned method: Under these agreements, the employer owns the policy, pays the premiums and assumes control of the policy. While the designated beneficiary for the death benefit is the employee, at least in part, the employer alone has access to the insurance's cash value.
- Employee-owned method: This type of agreement gives employees autonomy and control over the life insurance policy's features and benefits. The employee takes on the role of policy owner, and so can make policy decisions and access the policy’s cash value. However, the employee must make the employer a partial beneficiary of the death benefit. Specifically, the company will receive a payout that is at least equivalent to its premium contributions.
Taxation of split-dollar life insurance
How split-dollar insurance proceeds are taxed depends largely on the ownership structure of the agreement. The implications are complex, and can best be explained and handled by a tax expert. However, here are some general expectations.
When the employer owns the policy, contributions to the premium are deemed to provide the employee with an economic benefit. The value of those contributions generally must be declared as taxable income by the employee. In turn, the company should be able to take a tax deduction on the premium payments it makes to the policy.
If, however, the employee owns the policy, the premiums paid by the employer will be considered a loan to the employee rather than a full economic benefit. Ordinarily, of course, consumers pay interest on loans.
However, many split-dollar arrangements do not require the employee to pay interest. Since that absence of interest is considered to be a workplace perk, the worker must calculate the market value of the interest they’ve been spared and declare it as a taxable benefit.
Collateral assignment
The term “collateral assignment” arises with the employee-owned type of split-dollar life insurance. In this arrangement, some benefits are assigned to the employer, such as repayment of the premiums it paid on behalf of the employee.
Ideally, the policy’s cash value is sufficient to handle those obligations. But employee-owned split-dollar life insurance agreements must address where responsibility resides in the event that, upon the employee’s death or departure from the company, the cash value of the underlying policy falls short of what’s needed to repay the employer, as per the plan’s details.
There are at least three potential levels of recourse – from none to full – for the employer to ensure they’re made whole in the instance that the account lacks the funds to do so.
- Non-recourse arrangements: These lean entirely on the insurance policy itself to repay the employer, to the fullest extent it can. That means the employee, or their estate, won't be responsible for covering any policy shortfall required to repay the premium and associated interest to the employer. That said, any shortfall could be taxable to the employee as the cancellation of debt income.
- Limited recourse arrangements: Like non-recourse agreements, these still rely primarily on the insurance policy to repay principal and interest owed to the employer. Should those funds come up short, though, the arrangement allows the employer to call upon the employee or the employee’s estate to make up the deficiency.
- Full-recourse arrangements: These resemble limited-recourse arrangements, but with a greater potential burden for the employee. Full-recourse agreements allow the employer, in case of a shortfall in the amount needed to make them whole, to go directly to the employee for the funds. The employee would then have the burden of working with the life insurer to recover what they were required to pay.
Potential cash value growth and accumulation
Split-dollar life insurance policies include a cash value component, which is a savings or investment feature that enables you, as the policyholder, to accumulate a cash reserve over time. The policy owner can tap into this accrued cash value during their lifetime, giving them access to the funds.
When the policy is employee-owned, the individual can use the cash value as a supplemental financial resource. These funds can serve multiple purposes, including boosting a retirement fund or providing a safety net during unforeseen emergencies.
Loan repayment
A split-dollar life insurance agreement often permits the policyholder to borrow against the cash value of the policy. The borrowed amount must be repaid with interest to keep the policy active. If the employer is the policy owner, it can make a loan to the employee, with the employee using the policy's accumulated cash value as collateral.
The employee is then responsible for repaying the loan. However, if the employee leaves the company, they may have to pay back all the money. Once again, the repayment schedule will depend on the wording of the arrangement.
In the event of the insured's passing, the policy deducts any outstanding loans granted to the policyholder from the death benefit before disbursing it to the designated beneficiaries.
Types of split-dollar arrangements
There are two main varieties of split-dollar life insurance arrangements: endorsement split-dollar agreements and loan-based split-dollar agreements.
Endorsement split-dollar agreements
With this type, the employer endorses the policy and pays the premiums. The company will also receive back any premium contributions in the event of the employee's death, with the death benefit going to the employee's designated beneficiaries.
Loan-based split-dollar
Loan-based split-dollar arrangements involve the employer providing loans to the employee to cover the premium payments for the agreement’s underlying life insurance policy. These loans accrue interest over time.
After the insured passes away, the outstanding loan amount is deducted from the policy’s death benefit. The policy pays the remaining amount to the employee's beneficiaries. This type of arrangement can be more complex than the endorsement one, due to the interest calculations and the potential need for ongoing loan management.
The benefits and drawbacks of split-dollar life insurance
Employers, in particular, will want to examine the pros and cons of split-dollar life insurance. These agreements are far more complex than a mere life insurance policy, such as coverage under term and whole life insurance.
Split-dollar life insurance benefits
Here are a few of the benefits of split-dollar life insurance.
Financial protection against the death of a key employee
The death of a high-value employee, such as an executive, can easily lead to lost revenue as the company adjusts to the loss and mobilizes to fill the gap left in the organization. The payout from a split-dollar life insurance arrangement can help soften the short-term blow to the company’s bottom line.
A perk to attract and retain talent
A split-dollar arrangement for important employees can nicely round out a company’s executive compensation package. In so doing, it can not only help secure current employees but increase the company's allure to key workers in future.
Potential cash value growth
The cash value of a split-dollar life insurance policy can grow over time, either from interest or investment gains. In many cases, the policy owner can access those funds. There may even be a chance for that individual to borrow or withdraw money from the policy, and enjoy a supplementary source of financial help for emergencies or retirement planning.
Split-dollar life insurance drawbacks
Along with the advantages of split-dollar life insurance, you also need to consider the potential downsides to these agreements.
The complex nature of split-dollar life insurance
These agreements can be hard to grasp, since they are complicated and few employers or employees are well-versed in the intricacies of insurance and the tax law that governs it. Split-dollar life insurance plans typically require the involvement of attorneys, financial advisors and insurance professionals to structure the arrangement correctly.
One example of the complexity of these plans: split-dollar life insurance arrangements may be subject to regulatory review under the Employee Retirement Income Security Act (ERISA). This legislation sets standards for employee benefit plans, including retirement plans, health plans and other employee welfare benefit plans.
Tax and legal compliance
The premium payments involved with split-dollar life insurance carry tax implications for employer and employee alike. Employers are more likely to enjoy a tax upside to the arrangement, since the premiums paid into the employee's plan may earn tax deductions as legitimate business expenses. For the employee, though, the IRS may treat the value of the life insurance coverage provided as additional taxable income.
Summary: What is split-dollar life insurance, and how does it work?
Split-dollar life insurance is a versatile tool employers can use to help provide special life insurance coverage to their most important workers. The coverage, which uses a permanent life insurance policy, can offer a perk to a C-suite leader or other key employee, and its costs can be offset with tax deductions afforded for expenses associated with workplace benefits.
Such an arrangement typically involves employer and employee agreeing upon which party pays the premiums, how the death benefit will be divided and who owns the policy — with ownership affecting the respective advantages to (and tax implications for) each party to the agreement.
If the employee owns the policy, they can borrow from the cash value in the account, and the employer often doesn’t charge interest on the loans, as is customary with permanent life insurance. But if no interest is charged, that fact is considered to be a workplace perk and the employee can be taxed on the interest they’re been spared.
A company and employee alike that’s considering split-dollar life insurance should work closely with financial advisors, tax experts and legal professionals to ensure that the arrangement aligns with the financial goals of both parties as well as adhering to relevant regulations.