Companies seeking to retain their key personnel should consider an Executive Bonus Life Insurance Plan. This plan is based on the Internal Revenue Code Section 162, which allows employers to deduct ordinary and necessary business expenses such as salaries and employee benefits from taxable income. This guide will discuss an Executive Bonus Life Insurance plan, how it works, why it could benefit executives looking to maximize their savings potential, and the use of annuities instead of life insurance. Learn more about how this unique plan can provide extra financial security for your future!
- A Look at Section 162 Executive Bonus Plan
- How Does The Section 162 Bonus Plan Work?
- Single vs. Double Bonus:
- Executive Bonus Plan Example
- Tax Implications:
- Eligibility and Credit Protection:
- Retirement and Death Benefits:
- Executive Bonus Plan Pros and Cons
- Using Annuities for 162 Executive Bonus Plans
- Next Steps
- Section 162 Executive Bonus Plan Quotes
- Frequently Asked Questions
A Look at Section 162 Executive Bonus Plan
The Section 162 Executive Bonus Plan, often called an executive bonus plan, is a method companies use to incentivize and reward their key employees. Named after the relevant section in the IRS Code, this plan allows businesses to offer tax-deductible bonuses to top-tier executives, often through life insurance policies. The executive, in turn, owns the policy and benefits from the insurance coverage and potential cash value growth.
Key Takeaways:
- This plan is a strategy used by businesses to reward and retain essential employees, often executives or “key” team members, whose departure could significantly impact the business.
- The plan involves the employer providing a bonus to the employee, which is used to pay for a life insurance policy. The employee owns the policy and designates the beneficiary.
- Duel Tax benefits for both the employer and employee
- A deferred annuity may be more advantageous to both the employer and employee than whole life insurance
Additional Reading: Key Man Insurance
How Does The Section 162 Bonus Plan Work?
- The company compensates the key executive with a taxable bonus as income to the recipient. The bonus is usually treated as an ordinary business expense for the company.
- The bonus purchases a deferred annuity, whole life insurance policy, or universal life insurance policy that builds cash value that grows tax-deferred. The company restricts cash surrender value access until a specific date.
- Any life insurance cash value accumulation will grow tax-deferred and may be accessed by the employee income tax-free through withdrawals and policy loans. The cash value can be used to supplement retirement income.
- If the key executive dies, their heirs will receive death benefit proceeds from an insurance policy free of income tax.
Single vs. Double Bonus:
- In a single bonus arrangement, the employer pays the life insurance premium as a bonus, and the employee is responsible for the income tax on the bonus.
- In a double bonus arrangement, the employer covers both the premium and the tax liabilities, minimizing the financial impact on the employee.
Executive Bonus Plan Example
A company wants to provide an additional benefit to its CEO. The company might choose an executive life insurance policy under a Section 162 plan. The business pays the premiums, treating them as a bonus, while the CEO is the policy owner and beneficiary. If the policy has a cash value component, the CEO can access this, creating a potentially significant tax-advantaged benefit.
Tax Implications:
- The bonus is generally tax-deductible for the employer and considered taxable income for the employee.
- Life insurance proceeds are typically free of federal income tax for the employee’s beneficiaries.
- The plan doesn’t attract corporate Alternative Minimum Tax (AMT) because the business doesn’t own the policy.
At the center of this plan is IRS Code 162, which allows businesses to deduct expenses that are ordinary and necessary for carrying out their trade or business during the taxable year. This also covers reasonable salary allowances or other forms of compensation for personal services provided.
Eligibility and Credit Protection:
- Employers have the discretion to select which employees receive this benefit. However, it’s not suitable for all business structures, particularly those where the business and owner are not separate taxable entities.
- The life insurance policies are not business assets, so they’re protected from business creditors.
Retirement and Death Benefits:
- Employees might pay additional premiums to increase the policy’s cash value, which can be used as retirement income.
- Upon the employee’s death, beneficiaries receive the death benefit, usually tax-free.
Related Reading: Supplemental Executive Retirement Plans
Executive Bonus Plan Pros and Cons
| Pros | Cons |
|---|---|
| Easily implemented and administered. | If the key executive dies, the company cannot fully recover its costs from the policy’s death benefit. |
| The company can decide which key employees to reward. | Key executives can immediately access the cash value and withdraw that amount without taxes through loans unless restricted. |
| Bonus payments may be fully deductible to the company. | The key executive must include any bonus in their taxable income. |
| The key employee can name the death benefit beneficiary. | The company may face reputational risk or IRS penalties if the bonus plan is perceived as overly generous or exclusive to certain employees. |
| Key executives can immediately access the cash value and withdraw that amount without taxes through loans unless restricted. | The executive may become overly reliant on the bonus for financial planning and stability. |
| Not subject to the qualified plan limits that affect other company retirement plans. | Key executive can immediately access the cash value and withdraw that amount without taxes through loans unless restricted. |
Using Annuities for 162 Executive Bonus Plans
Employers often use an executive life insurance policy to provide executive bonuses, but these policies have limitations that make them a less effective compensation option.
Employers could use an annuity instead of a life insurance policy to offer performance incentives. In addition, it is easier for employers to vary the contribution from year to year with an annuity than it is a life insurance policy.
Advantages for Employer
- Tax Deduction: The business obtains a full tax deduction for the bonus paid into the annuity.
- Selective Rewarding: The bonus can be selectively applied, targeting employees in the top 15% of earners.
- Additional Bonus Option: The employer can provide a second bonus to cover the tax on the bonuses, enhancing the net benefit to the employee.
- Immediate Deduction: The company gains an immediate tax deduction with the 162 Executive Bonus Plan.
- Flexible Funding with Annuity: Using an annuity allows employers to easily vary the contribution from year to year compared to a life insurance policy.
- Deductible Bonus: The bonus used to fund the annuity is deductible.
- Retention Strategy: Employers can implement a strategy by having employees agree to repay bonuses if they leave during an agreed period.
Advantages for Employee
- Immediate Income: The executive takes the bonus into income in the current year.
- Immediate Income from Bonus: The employee receives immediate income through the bonus.
- Potential Additional Bonus: There’s a potential to receive a second bonus to cover tax liabilities.
- Benefit from Deferred Annuity: If the employer funds a deferred annuity owned by the annuitant/key employee, they can benefit the employee.
Next Steps
The Section 162 executive bonus plan is a powerful tool in business financial planning. It offers compelling benefits for the company and the executive but has certain disadvantages that must be carefully considered. By understanding these nuances, you can make more informed decisions and traverse the labyrinth of financial planning with confidence.
Section 162 Executive Bonus Plan Quotes
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Frequently Asked Questions
Who is the owner in an executive bonus plan?
The owner of an Executive Bonus Life Insurance Plan is typically the employer. As the policyholder, the employer pays premiums and receives a tax deduction for these payments. In addition, the employee’s beneficiary will receive the death benefit from the policy when they pass away.
Are executive bonus plans portable?
Most executive life insurance policies are not portable, meaning employees cannot take the policy with them when they leave the company. However, depending on the plan, it may be possible to transfer or assign the policy to another employer while maintaining its tax-free status. It is essential to check with your plan administrator for more details.
How are executive bonus plans funded?
Executive bonus life insurance plans are typically funded by the employer, who pays for the premiums regularly. The employee does not make any payments towards their policy and only receives the death benefit when they pass away.
Is an executive bonus plan taxable?
Generally, the death benefit of an Executive Bonus Life Insurance Plan is not taxable. However, any dividends or other cash values from the policy may be subject to taxation. Therefore, checking with your plan administrator for more information is essential.
Can employers deduct an executive benefit plan?
Yes, if the employer provides an executive bonus plan and pays for the premiums, they may be able to take a tax deduction. This is based on Internal Revenue Code Section 162, which allows employers to deduct ordinary and necessary business expenses such as salary, bonuses, and other compensation, including benefits.