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If you're looking for a unique benefit solution that will provide your financial institution's key executives with life insurance and supplemental retirement benefits, split-dollar life insurance fits the bill perfectly.
What is Split-Dollar Life Insurance?
Split-dollar life insurance is a method that a financial institution can use to provide a life insurance policy—and the associated cash values that go with it—to a key executive. The cash value element of the life insurance policy can provide supplemental retirement income for the key executive. The death benefits of the life insurance policy can provide a benefit for the executive’s family (beneficiary) in the event of the executive’s premature death. Also, the financial institution receives a death benefit to recover the premiums paid for the life insurance policy. The plan can be designed to provide the financial institution with a recovery of the cost of funds used in allocating assets to this very important executive benefit plan.
Split-dollar life insurance can be designed in two ways:
1. The endorsement method (economic benefit regime)
2. The loan regimen method (better known as collateral assignment split dollar or CASD)
Differences Between Plan Arrangements
Endorsement (economic benefit) method
In the endorsement method, the life insurance policy is owned by the financial institution, with the key executive listed as the insured. The beneficiary is typically split between the institution and the key executive’s named beneficiary. The institution pays the premium.
The institution endorses part of the cash value (the policy cash value in excess of the institution's premium contributions to the policy) to the executive. The policy death benefit is also split, with the institution retaining enough death benefit to recover its cumulative premiums paid into the policy and the remaining death benefit going to the key executive’s beneficiary. In some cases, the institution may retain death benefit coverage as key person life insurance on the executive in order to help the institution gather money to help replace the executive in case of premature death.
The key executive must pay income tax annually on the economic value of the executive's death benefits portion of the life insurance protection. The value of the executive’s portion of the death benefit is determined by using IRS table 2001.
When endorsement method split-dollar life insurance is intended to provide a supplemental retirement income for a key executive, the plan takes on some unique characteristics. If the plan is owned by a non-profit business and provides a retirement benefit (economic benefit) to the key executive, the plan becomes subject to IRS code sections 457(f) and 409(A).
Code section 457(f) has certain aspects that make the plan less favorable than the collateral assignment split-dollar arrangement. The plan is subject to a substantial risk of forfeiture. As long as the executive isn’t entitled to a cash benefit (retirement benefit) or the executive doesn’t vest in the plan, there is no current income taxation (deferred income taxation) until there is no longer a substantial risk of forfeiture.
Collateral assignment split-dollar life insurance arrangement (CASD)
In the collateral assignment split-dollar arrangement, the key executive is the owner and insured of the life insurance policy. The financial institution pays the premiums on the policy by making a loan to the executive for the annual premium. This is booked as a long-term asset on the institution's balance sheet. The beneficiary of the policy is split between the institution (to recover the outstanding loan) and the executive’s beneficiary. The executive executes a collateral assignment of the life insurance policy to the institution as collateral for the premium loans.
In the CASD arrangement, the loan from the institution to the key executive is usually an interest-free loan. When the loan is structured this way, it is a below-market loan subject to IRS code 7872. Code section 7872 states that the interest on the loan will be imputed to determine the interest that should have been paid on the loan. This is referred to as the "applicable federal rate" (AFR). This imputed interest is taxable to the executive each year and is based on the cumulative outstanding loan. The rate of imputed interest depends on whether the loan is a demand loan or a term loan. A demand loan is any loan payable in full at any time on demand of the lender. To the extent provided in the regulations, such term also includes any loan with an indefinite maturity. A term loan means any loan which is not a demand loan.
To offset the impact of this additional income and the income tax on it for the key executive, the institution gives the executive a bonus to offset the income tax. This bonus can be “grossed-up” to offset the income tax on the bonus.
When the key executive vests in the plan benefits, the vesting doesn't trigger a taxable event (as the endorsement method does). When the executive begins to withdraw benefits (supplemental retirement income), the withdrawals are income tax free up to the basis in the life insurance policy. Therefore, the amount of premiums paid into the life insurance can be withdrawn income tax free.
It's always a challenge to keep the best people on your financial institution's payroll. When you provide a valuable executive benefits package, including split-dollar insurance, you prove your institution's dedication to providing a total compensation package that gives key executives a convincing reason to stay put.
Member SIPC & FINRA. Advisory services offered through SWBC Investment Company, a Registered Investment Advisor.
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Roger Versteeg joined SWBC in October 2007 as part of SWBC Executive Benefits. Roger has more than 33 years of insurance and financial services experience, specializing in non-qualified deferred compensation and succession planning for credit unions. As an award-winning executive benefits professional, Roger has qualified numerous times as a lifetime member of the Million Dollar Round Table™ Top of the Table. Roger is a member of the Mankato, Minnesota Chapter of the Society for Financial Services Professionals, the National Association of Independent Financial Advisors, and he has served as President for the Southern Minnesota division of each group. His humble philosophy is to make every conscientious effort to serve his clients in the same manner as he would apply to himself.