The Section 162 Executive Bonus Plan is a type of compensation that may be paid to an executive or employee of a company. Executive bonus plans provide a means for business owners to reward their outstanding key executives where the owner may be concerned that a competitor could hire them away. If you are thinking about implementing a Section 162 Executive Bonus Plan, these are some things you should know:
What is a 162 Executive Bonus Plan?
When companies or business owners want to provide additional perks to their key employees, they can use a 162 executive bonus plan. Benefits are usually in the form of a permanent life insurance policy that accrues cash value that can be used as the employee’s retirement income in the future. The cash value is tax-deferred, while the death benefit is tax-free for the employee’s beneficiaries.
The tax-deductible executive benefits plan is a beneficial tool for businesses to attract and retain key executives.
A few different types of Executive Bonus life insurance policies are available, including single-premium and flexible-premium policies. With a single-premium policy, the entire premium is paid upfront, and the policy does not have any annual premiums. A flexible-premium policy has both an up-front premium and annual premiums, but the policyholder has the flexibility to choose how much they want to pay each year.
Additional Reading: Key Man Insurance
How Does The Section 162 Bonus Plan Work?
- The company compensates the key executive with a bonus that is taxable as income to the recipient. The bonus is usually treated as an ordinary business expense for the company.
- The bonus is used to purchase a deferred annuity, whole life insurance policy, or universal life insurance policy that builds cash value that grows tax-deferred. The company restricts access to the cash surrender value until a specific future 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.
Executive Bonus Plan Pros and Cons
- An executive bonus plan can be implemented and administered easily.
- A company can decide which key employees they want to bestow the rewards on.
- The bonus payments may be fully deductible to the company.
- The key employee can name the death benefit beneficiary, who will receive all life insurance policy benefits.
- Unless there is a “controlled or restricted executive bonus,” the key executive will have immediate access to the cash value and may withdraw that amount without taxes through loans.
- Executive bonus plans are not subject to the qualified plan limits that affect other company retirement plans.
- If the key executive dies, the company cannot fully recover its costs from the policy’s death benefit since the executive designates the policy’s beneficiary.
- Executive bonuses offer very little control to the company except for restricting a key employee’s access to cash values in the policy. Any amount of money this person may have vested before leaving is never recouped by the company.
- The key executive should include any bonus in their taxable income.
162 Executive Bonus Plan Using an Annuity
A 162 Executive Bonus works for business owners because the business gets a full tax deduction for the bonus paid into the annuity. The executive takes the bonus into income in the current year.
The bonus applies only to those employees in the top 15% of earners.
The employer could provide a second bonus sent to the IRS to cover the tax on the two bonuses provided.
With a 162 Executive Bonus Plan, the company gets an immediate deduction, and the employee receives immediate income. In addition, if the employer funds a deferred annuity owned by the annuitant/key employee, they can provide a benefit to the employee.
Employers often use life insurance policies to provide executive bonuses, but these policies have limitations that make them a less effective compensation option.
Employers should use an annuity instead of a life insurance policy when they want 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.
The employer can provide the employee a benefit and yet deduct the bonus for funding the annuity.
The employer can have the employee sign a document agreeing to repay bonuses if they leave during their agreement.
Executive bonus plans offer a wide variety of benefits to employees. If you are looking for a way to provide additional perks to your key employees, consider using an executive bonus plan. These plans can be customized to fit the needs of your business and employees, and they come with a number of tax advantages. To learn more about how executive bonus plans could benefit your business, please contact us today. We would be happy to discuss this option further with you and answer any questions you may have.