Classic 401(k) and 401(k) Look-Alike plans have long been the retirement vehicle of choice for many employers. In both 401k (qualified) and 401k Look-Alike (non-qualified) plans, the employee participants choose to defer a portion of their income and thereby defer the income taxes due on that income. Employers also defer a tax deduction on that compensation and create a liability on their balance sheet. Yet these plans do little to improve key employee retention.
Is there an effective solution?
A Section 162 Executive Bonus Plan is a flexible arrangement to attract and reward key employees. This is by far the most discretionary and customizable incentive/retention plan available. By matching key employee contributions or paying a year-end bonus, you can reward key employees and give them strong financial incentives without many of the costs and challenges associated with a traditional retirement plan.
When properly structured, these plans…
• Can be offered to selected key employees
• Are a tax deduction for your business (as long as compensation is reasonable), and
• Do not create a liability on your balance sheet
How a Bonus Plan Works
An Executive Bonus Plan is an arrangement where an executive purchases an Indexed Universal Life (IUL) policy to provide death benefit protection and to help accumulate funds for retirement. The arrangement can be funded through employer contributions (as a § 162 bonus plan), through after-tax contributions from the executive, or a combination of both. While premium payments must be treated as ordinary income, the executive has the option to borrow money from the IUL insurance policy to pay income taxes. The executive can use the policy as a source of supplemental retirement income, as a source of survivorship benefits, or both.
Steps for Implementing an Executive Bonus Plan
- The company and the executive agree that personal life insurance protection and the related potential cash value accumulations are important components of the executive’s overall compensation package.
- The executive purchases an IUL policy insuring his or her life.
- The company makes the premium payments on this policy, which are taxed as additional compensation to the executive and create a current deduction for the employer. Optionally, the company may provide an additional cash bonus to the executive to cover the income tax associated with the premium payment.
- The executive may opt to pay the income taxes on the bonused premium payments by borrowing money from the IUL policy utilizing a loan provision.
- The policy cash values may be available to supplement the executive’s retirement income through tax free withdrawals and loans. The policy death benefit generally will be paid income tax free to the executive’s beneficiaries.
Potential Advantages
- Current tax deduction for employer on bonus payments (if reasonable compensation)
- Selective benefit
- Simple administration
- Reduced expenses when compared to a qualified plan over the long-term.
- Tax-Free income(1) – Provided the life insurance policy is not structured as a modified endowment contract (MEC), the executive will be able to attain tax-free income through a combination of policy withdrawals and loans.
- Income tax-free death benefit(2)
- No IRS distribution requirements or penalties – Policy distributions from an Executive Bonus arrangement can occur before age 59 1⁄2 without a premature distribution penalty from the IRS, and there are no required minimum distributions at age 70 1⁄2 or thereafter.
Potential Disadvantages
- Immediate taxation to executive on bonus payments
- No cost recovery for employer
- No “Golden Handcuffs”
Want more info?
We can help you determine if an Executive Bonus plan is the best fit for you and your key employees. To learn more please give us a call or send us an email.
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- A portion of the policy’s surrender value may be available as a source of supplemental retirement income through policy loans and withdrawals. Income tax free policy distributions may be achieved by policy loans or withdrawing to the cost basis (usually premiums paid). This assumes the policy qualifies as life insurance, is not a modified endowment contract and is not lapsed or surrendered with an outstanding loan. Policy loans and withdrawals may reduce or eliminate index credits, generate an income tax liability, reduce available surrender value and reduce the death benefit, or cause the policy to lapse. Detailed additional information about policy loans is located in the policy form and any personal policy illustration.
- Proceeds from a life insurance policy are generally income tax-free, and if properly structured, may also be free from estate tax.
- Vesity Financial Inc and Chris Nesbitt do not give tax or legal advice. The plans discussed are not intended to and cannot be used to avoid tax penalties. Each taxpayer should seek advice from an independent tax advisor. This information is general in nature and not comprehensive, the applicable laws change frequently and the strategies suggested may not be suitable for everyone. Always seek advice from tax and legal advisors.