The most widespread form of life insurance is for personal use and usually protects a family financially if their loved one dies. Life insurance can also be used to cover the economic repercussions any business may see if a key person in the business dies suddenly.
Many businesses mitigate this risk using split dollar life insurance, which is an agreement created between at least two parties that share the benefits and ownership of a permanent life insurance policy and its cash value component. Typically, businesses choose whole life insurance or indexed universal life insurance policies for this arrangement.
Understanding How Split Dollar Life Insurance Works for Businesses
Split-dollar life insurance is commonly used by companies to mitigate the financial risk that results when a key employee or executive dies or as part of an executive compensation package.
This type of life insurance arrangement allows employers and employees to split the premium payments, the policy’s ownership, and the benefits. This structure provides a valuable financial safety net for businesses while offering significant benefits for the covered employees.
How Split Dollar Life Insurance Works
Split-dollar life insurance is a type of policy jointly owned by two parties. The policy’s death benefit is divided between the owners based on their contributions to the premium payments. This setup allows both parties to share in the benefits while maintaining control over their own investments.
How Does Split Dollar Life Insurance Work for Employers and Employees?
In a typical structure, the employer pays the insurance premiums, while the employee is named as the policy beneficiary. Some plans may also deduct premiums from the employee’s paycheck. There are several advantages to this arrangement:
- Employers can use it as a tool to attract and retain key employees.
- Employees receive valuable death benefits for their beneficiaries, providing long-term financial security.
Here are the key elements that both the employer and employee must agree upon when setting up a split dollar life insurance plan:
- Who will pay the premiums?
- Who will own the policy?
- How will the cash value and death benefits be divided?
- Who will be the beneficiaries?
- What circumstances will terminate the plan?
Types of Split Dollar Life Insurance Plans
There are two primary types of split dollar life insurance plans: Collateral Assignment Split Dollar and Endorsement Split Dollar. Each has distinct characteristics and advantages depending on the needs of the employer and employee.
Collateral Assignment Split Dollar
In this arrangement, the employee owns the life insurance policy, while the employer has a collateral interest in the policy’s cash value and death benefit. This type of plan allows the employee to build up the cash value of the policy over time, giving them more control over the policy while ensuring the employer’s contributions are repaid upon the employee’s death.
- Employee-Owned: The employee holds ownership of the policy and may have access to the cash value as it grows.
- Employer’s Interest: The employer is reimbursed for the premiums they have paid through the death benefit or cash value when the employee dies.
This plan is typically favored by employees who want to take advantage of the policy’s cash value and have more control over their own financial future.
Endorsement Split Dollar
In the endorsement arrangement, the employer owns the policy and endorses a portion of the death benefit to the employee. This structure ensures that the employer maintains control over the policy and uses it as an incentive or retention tool.
- Employer-Owned: The employer retains ownership of the policy and can use the cash value or death benefit to recover the cost of the premiums.
- Employee’s Benefit: The employee or their beneficiaries receive a portion of the death benefit, providing financial security in the event of the employee’s death.
This plan is more commonly used by employers who want to offer it as a part of an executive compensation package or as a business protection strategy.
Using Split Dollar Life Insurance in Estate Planning
Split dollar life insurance is also an effective estate planning tool. It offers significant tax benefits for the policyholder and beneficiaries, particularly in large estates.
With a split dollar life insurance policy, the premiums are typically paid by both the policyholder and the beneficiary. The death benefit is divided between them, and because the premiums are paid with after-tax dollars, the death benefit is not subject to estate taxes.
Additionally, the policy can help create an inheritance for your beneficiaries without impacting your estate tax exemption. This makes split dollar life insurance an appealing option for those looking to maximize their estate for future generations.
For even greater tax protection, you can establish an irrevocable life insurance trust, which protects life insurance proceeds from estate taxes.
The Pros and Cons of Split Dollar Life Insurance
Advantages
- Tax-Free Death Benefits: The death benefit received by your beneficiaries is typically tax-free, which is a significant advantage, especially for individuals in higher tax brackets.
- Flexibility: The policy can be tailored to meet both employer and employee needs.
- Business Continuity: It provides a financial safety net for businesses in case a key employee passes away.
- Estate Planning: Split dollar insurance can help you plan your estate by creating an inheritance without impacting tax exemptions.
Disadvantages
- Complexity: The split dollar insurance structure can be confusing due to its many options.
- Tax Reporting: The involved parties often require assistance from a CPA to handle IRS reporting requirements.
Frequently Asked Questions About Split Dollar Life Insurance
What are the benefits of split dollar life insurance for business owners?
Business owners can use split dollar life insurance to protect their company from the financial impact of losing a key employee. It also serves as an executive benefit to attract and retain top talent.
Can I use split dollar life insurance for estate planning?
Yes, split dollar life insurance is commonly used in estate planning. Its structure allows you to transfer wealth to your beneficiaries without affecting your estate tax exemption, especially when combined with an irrevocable life insurance trust.
How does split dollar life insurance affect taxes?
The death benefit from a split dollar life insurance policy is typically tax-free. However, parties involved must handle complex tax reporting, which often requires help from a CPA.
What is the difference between split dollar life insurance and key person insurance?
While both types of insurance help mitigate business risks related to losing key employees, key person insurance solely benefits the business. Split dollar life insurance splits the benefits between the business and the employee, making it a more flexible arrangement.
How do I set up a split dollar life insurance policy?
To set up a split dollar life insurance policy, businesses and employees need to negotiate terms regarding premium payments, ownership, and how the death benefit will be divided. It’s essential to work with an experienced advisor to structure the policy correctly.
If you’re considering split dollar life insurance for your business or estate planning, it’s crucial to consult with a financial advisor who can help determine the best structure for your needs.
