Split-dollar life insurance is an arrangement where parties, such as employers and employees, share the costs and benefits of a life insurance policy. These agreements govern premium payments, policy ownership, and benefits distribution, serving as both an employee incentive and a tool for tax and estate planning.
Reviewed by W&S Financial Review Board May 23, 2024
Most life insurance policies are owned, managed and paid for by one person. Still, there are situations where two parties could benefit from the coverage. For example, if a high-level executive passes away, their family and company would face a financial loss. In such cases, the two parties might consider sharing a sizable policy through split-dollar life insurance. Read on to learn more about this type of life insurance and when it might make sense for you.
What exactly is split-dollar life insurance? It's an agreement between two or more parties to share the costs and benefits of a policy. The split-dollar agreement is a legal contract laying out how this works. There are several ways to set one up. The defining point is that multiple parties divide parts of the policy, rather than one person paying all the costs and receiving all the benefits. A split-dollar policy is commonly used between companies and key employees/executives.
Split-dollar life insurance starts with two parties determining how to divide a life insurance policy. The agreement covers details such as:
The insured person then applies for a policy on their life. Split-dollar agreements usually use permanent life insurance policies with no expiration and cash value. Whole life insurance tends to be the most popular choice because the death benefit and premiums stay the same over time, making it predictable for both sides.
If the insured qualifies for life insurance, the two parties sign their split-dollar agreement. They then pay the premiums and manage the policy per their agreement. If the insured passes away, the employer collects their agreed share from the death benefit before the remainder goes to the insured employee's heirs. The employer might agree to collect up to what it paid to fund the policy, the policy's cash value or some other amount set by the agreement.
Now that you have a basic understanding of, "What is split-dollar life insurance?", let's look further into the details. There are different types of split-dollar agreements depending on who owns the life insurance policy.
In this arrangement, the employer owns the life insurance policy. The employer signs an endorsement agreement pledging to give the employee's beneficiaries their share of the death benefit. The agreement specifies whether the employer continues owning the policy after the employee retires or if it gives the policy, including the cash value, to the employee.
If the employee owns the policy, the employer still makes the premium payments. However, the IRS treats these payments as a loan to the employee. This is known as a loan regime. When the employee retires, they can either pay off the loan for all the premium payments, or the employee can forgive the loan.
The employee then signs a collateral assignment agreement. This agreement uses the life insurance death benefit as collateral, a valuable asset available to repay the ongoing loan. In the event of the employee's death, the death benefit pays off the loan before the remainder goes to the employee's beneficiaries.
Collateral assignment split-dollar agreements are less common because of government restrictions. Publicly traded companies can't lend money to their executives, so they can't use these agreements.
A private split-dollar agreement can be used outside of work as an estate planning tool, another benefit of life insurance. The insured buys a policy through an irrevocable life insurance trust (ILIT). Doing so can help reduce future estate taxes. Usually though, buying a policy through an ILIT means the insured can't get any money back from the policy; it's irrevocable. However, the private split-dollar agreement could include the right to get some amount back if desired, such as the total premiums paid or the policy's cash value.
An employee, employer or trust fund could own a split-dollar insurance policy, depending on the agreement. In an endorsement agreement, the employer owns the policy. In a collateral assignment agreement, the employee owns the policy. In a private split-dollar agreement, a trust fund owns the policy. Each approach has different pros and cons for the costs, taxes and benefits.
The employee names the beneficiary in a split-dollar plan. However, the split-dollar agreement lays out how much of the death benefit must go to the employer before any remaining money is paid to the listed beneficiaries. This applies to both types of workplace split-dollar plans.
If the insured transfers a policy to an irrevocable trust for a split-dollar plan, they typically cannot change the beneficiary afterward. It's part of the transfer being irrevocable.
Each type of split-dollar agreement comes with different tax implications.
Split-dollar taxation depends on the type of agreement. In an endorsement agreement where the employer owns the policy, the premium payments count as taxable income for the employee based on the value of the life insurance.
In a collateral assignment agreement, the employee does not owe income tax for the annual premium payments. However, the employee is supposed to pay their employer interest on the loan balance at a market rate determined by the IRS. If the employer doesn't charge interest or charges a below-market rate, the employee must report the annual interest savings as income and pay taxes on the amount.
At the end of the agreement, such as when the employee retires, they can pay off the loan, or the employer could waive it. If the employee pays off the loan, they won't owe taxes. If the employer forgives the loan, the employee must declare the forgiven balance as taxable income.
The same tax advantages of any permanent life insurance policy apply in both arrangements. The cash value in the policy grows tax-deferred. No taxes are owed as long as the money stays in the policy. Whoever owns the policy could withdraw up to the total premium payments tax free. They only owe income tax for taking out gains above what was paid in premiums. If the insured dies, their beneficiaries receive the death benefit income tax free.
A private split-dollar agreement with an ILIT can reduce future estate taxes. If the insured owns a life insurance policy when they die, the entire death benefit goes into their taxable estate. However, if they set up the policy through an irrevocable trust, the death benefit would no longer be part of their estate.
In 2024, someone can give up to $13.61 million at death without owing estate taxes, but anything over this exemption is taxed. Seventeen states also charge estate and inheritance taxes, with some having much lower exemptions — Massachusetts starts taxing at $1 million, for example. Private split-dollar agreements can help minimize these taxes.
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Extra compensation for key employees: Employees can receive a substantial life insurance policy paid for by their employer through a split-dollar agreement. The employee might also get access to the policy cash value, leading to extra money they could use in retirement. Split-dollar agreements generally do not have the same restrictions and contribution limits as workplace retirement plans, such as a 401(k). This allows employers to give more money to executives and key employees through split-dollar plans.
Tax savings: The cash value in a split-dollar policy grows tax-deferred, the same as money in a 401(k) or retirement account. Private split-dollar agreements could create a larger inheritance by avoiding estate taxes on a life insurance death benefit.
Improves retention for employers: Employers can use split-dollar agreements to attract and retain highly skilled employees. They can write up the agreement where the employee receives more from the policy for working a stipulated number of years.
Protects both parties for the insured's death: If the covered employee dies, the employer and the employee's heirs receive a payout, as laid out by the agreement. There are benefits for both parties. The employer gets money to offset the loss of a key employee. The employee's loved ones receive money to address their life insurance needs .
Complex to set up and manage: Split-dollar life arrangements are more complex than regular life insurance policies. They typically require the help of financial and legal professionals to set up everything correctly.
Fewer tax benefits than before: In 2003, the government stopped allowing companies to use split-dollar agreements to give employees tax-free income through premium payments. This is why employees must report the premium payments as taxable income or pay market interest for the loans depending on the type of agreement.
Expensive policies: Split-dollar policies tend to be for larger permanent life insurance policies with sizable premiums. This is an ongoing cost for the company or the individual using one for estate planning.
The agreement could create friction between employers and employees: Employers and employees must understand both their split-dollar life insurance taxation responsibilities and benefits. Miscommunication can cause confusion, disagreements and even legal battles. For example, the employee's family expects to receive the entire policy death benefit but doesn't realize the employer will collect part of it.
Business owners could consider split-dollar life insurance to reward and retain key employees. It's a way to give a few essential contributors extra compensation beyond standard retirement plans, such as a 401(k). The boards and compensation committees of larger corporations use split-dollar life insurance for the same reason. Finally, someone with a sizable net worth concerned about owing estate taxes could use a private split-dollar policy to help minimize the tax hit.
Camila owns an advertising firm. She worries about her top salesperson, Elijah, leaving for a competitor. She offers Elijah a $2-million split-dollar whole life insurance policy using an endorsement agreement lasting 10 years. Camila pays the premiums during this time. If Elijah dies, Camila collects up to the total premiums paid (per the agreement), and the remaining death benefit goes to Elijah's family. If Elijah works for 10 years, Camila will transfer ownership of the policy and all cash value to Elijah, which he then can manage however he chooses.
Ronald wants to buy life insurance with a $10-million death benefit. If Ronald owns the policy when he dies, the entire $10-million death benefit becomes part of his taxable estate. Instead, he buys the policy through an irrevocable trust fund. He uses a private split-dollar agreement to recoup what he pays in premiums just in case he needs the money. Ronald both keeps the $10-million death benefit out of his taxable estate and maintains some access to the money paid into the ILIT.
Given its costs and complexity, split-dollar life insurance only makes sense in a few specific situations. This strategy could be right for you if you own a business and want to reward/retain a few high-value employees. If you are a high-level executive looking for more compensation, you could propose this agreement to your employer. Finally, if you think you might owe estate taxes one day, planning ahead with a split-dollar agreement can leave more money for your heirs.
These policies are too complicated to set up and plan without professional assistance. If you think this type of life insurance agreement might make sense for your situation, contact an experienced financial representative for more information and to discuss next steps.
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