A split-dollar life insurance arrangement lets two or more parties share the costs and benefits of a life insurance policy. It’s not a policy, strictly speaking, but a contract between the involved parties that defines who will pay the premiums and have access to the policy’s cash value and eventual death benefits. Employers commonly offer split-dollar insurance as a low-cost fringe benefit for highly compensated key executives. Getting the right kind and amount of insurance can be confusing so the insights of a financial advisor can be valuable.
Employers like split-dollar plans because they can encourage employee retention without making large financial commitments. For employees, split-dollar plans can help manage estate taxes and provide for heirs and dependents using life insurance.
How Split-Dollar Plans Work
A typical split-dollar plan calls for the employer to pay all or part of the premium for an insurance policy payable on the death of the covered employee. The policy may be a whole life policy, a universal life policy or other variety that builds cash value. The employer may pay the premiums directly or loan the employee money to pay the premiums.
A spit-dollar arrangement has three parts:
- A life insurance policy that may be owned by either the employee or the employer
- An insurance company assignment form describing the rights the employer and employee each have to the cash value and other benefits
- The split-dollar agreement with details on who will pay the premiums and how the death benefit will be distributed
The employer will get the right to receive some of the proceeds when the policy benefit is paid. These proceeds will repay the employer for the premiums it paid, plus interest. The employer may also have the right to some of the cash value.
The employee’s heirs will keep the remainder of the proceeds from the insurance policy after the employer has been reimbursed for the premiums and interest. This may also include all or some of the cash value of the policy.
Types of Split-Dollar Plans
In 2003, the Internal Revenue Service revamped the long-standing tax treatment rules for split-dollar plans. Since then, split-dollar plans have been recognized as two types. Each type is taxed differently. The two types are:
- Economic benefit plans – These plans typically call for the employer to pay an annual premium on a policy that the employer owns. When the policy pays off, the employer can claim part of the benefit to repay the loan.
- Loan plans – With these plans, the employer loans the employee the amount of the annual premium. Then the employee pays the premium and owns the policy. The agreement will call for the heirs or estate of the covered employee to pay the employer back for the loan using proceeds from the policy when the employee dies.
Tax Treatment of Split-Dollar Plans
The IRS levies taxes on the financial benefits that both types of split-dollar arrangements provide to employees. The two types of split-dollar plans are taxed differently, however.
Beneficiaries of economic benefit-type plans pay taxes on the economic benefit the plan provides the employee. The way the rules allow the taxable economic benefit to be calculated, it can be significantly lower than the actual amount of the premium that the employer is paying. This in effect shelters much of the value of the fringe benefit from taxation. However, an employee who owns the policy must report the economic benefit each year as income.
With loan-type plans, the premiums the employer pays are treated as loans to the employee. These loans have to specify what the IRS considers an adequate interest rate. If the rate isn’t high enough, the difference may be ruled an economic benefit and the employee may have to pay income taxes on the benefit.
Sometimes people covered by split-life plans set up an irrevocable life insurance trust as the owner of the policy. Doing this can cause the proceeds of the policy, when it pays off, to be excluded from the estate of the covered employee for federal estate tax purposes.
Split-dollar life insurance arrangements are popular ways for employers to provide low-cost fringe benefits that improve retention of key executives. These arrangements call for employers to pay for premiums of life insurance policies covering the key workers. The employer recoups the cost of the policy premiums when the policy pays off on the employee’s death. For employees, split-dollar plans provide a tax-efficient way to increase the size of their estates.
Tips on Insurance
- Using life insurance for estate planning can help minimize taxes and maximize benefits to heirs and dependents. A qualified and experience financial advisor can help navigate the complexities of split-dollar insurance plans and other approaches. SmartAsset’s free tool matches you with up to three financial advisors in your area, and you can interview your advisor matches at no cost to decide which one is right for you. If you’re ready to find an advisor, get started now.
- Use our free life insurance calculator to estimate how much life insurance you need.
Photo credit: ©iStock.com/alfexe, ©iStock.com/zimmytws, ©iStock.com/EHStock