Split Dollar Insurance

Split dollar insurance involves the purchase of life insurance where the ownership of the policy cash value and death benefit is divided. The executive owns a portion of each, and the company, which typically pays most or all of the premium, owns the remainder. The insurance can build an executive-owned cash value that, over time, produces security for the non-qualified benefits in a Non-Qualified Benefits Plan.

In January 2001, the IRS issued Notice 2001-10, which introduced a new "Interim Guidance" for tax treatment of split dollar insurance plans. These guidelines will have the effect of increasing the imputed income for the value of death benefits provided under split dollar insurance plans, and make clear that the IRS will tax transfers of economic value between employers and employees.

What are the advantages of using split dollar life insurance as a 401(k) look-alike plan?

1. Tax-free death benefit proceeds (including accumulated investment earnings and gains) to the policy owner's designated beneficiaries
2. Tax-deferred investment earnings and gains (often called "inside buildup")
3. Tax-free withdrawals up to the sum of premiums paid minus prior nontaxable withdrawals

Split dollar is not a type of insurance, it is a way to fund insurance. Essentially, the concept involves splitting the premiums, cash values, and death benefits between two parties. Normally the two parties are employer and employee. However, there is no reason why the two parties cannot be anyone who can benefit from sharing an insurance policy. For example, split dollar arrangements between two generations of a family, say a father and a son, are not uncommon. For the balance of this article, we'll focus on the more typical employee-employer situation.

Both the employer and employee benefit from a split dollar plan. The employee benefits because he needs the life insurance (to fund a buy-sell agreement, pay estate taxes, replace income, or some other need) and he wants to be able to buy it as cost effectively as possible. The employer benefits because he has a happy, productive, and loyal key employee. Under the basic structure of a split dollar plan the employee and the employer agree to share the premiums, cash value and death benefit of the policy. In the classic arrangement, the employer pays that portion of the premium attributable to the increase in cash value, while the employee pays the term portion. There is no requirement, however, that premiums be split in this way. In fact, in many split dollar arrangements the employer pays 100% of the premium. The employer has an interest in the cash values and the death benefit to the extent that it has paid premiums. Any amount of the cash value or death benefit over and above the amounts paid by the employer belong to the employee or his beneficiary.

Split dollar plans are a form of Non-Qualified Deferred Compensation plan. As such, the employer may be entirely selective in who can participate in the program. No IRS approval of the plan is necessary. There is a small tax cost to the employee. The employee must pay tax on the "economic benefit" of having his employer pay part of his insurance premium. This amount is computed using a special IRS table on term insurance rates published by the insurance company involved. You will frequently hear this imputed income referred to as the "P.S. 58" cost. This cost is very modest in most cases.

There are two types of split dollar plans. Under the "endorsement method" the employer owns the policy and assigns or "endorses" to the employee his rights to cash value and the death benefit. The endorsement method is appropriate for non-shareholder and minority shareholder employees. The other method is "collateral assignment" method. Under this method, used by majority shareholder employees, the employee owns the policy and assigns to the employer its rights in the cash value and death benefit as "collateral" for its premium payments.

Of course, this brief article is no substitute for a careful consideration of all of the advantages and disadvantages of this matter in light of your unique personal circumstances. Before implementing any significant tax or financial planning strategy, contact your financial planner, attorney or tax advisor as appropriate.

Is a split dollar insurance plan right for you? Contact your financial advisor to see.