Executive Benefits Series — Part 3
An IRS Section 162 Executive Bonus Plan allows a business to reward and retain a key employee by providing additional compensation that helps fund a personally owned life insurance policy.
The concept is straightforward:
- The employer selects the employee who will participate.
- The employer determines the amount of the annual bonus.
- The employee owns the life insurance policy.
- The employee uses the bonus to pay the policy premium.
Because the bonus is generally treated as taxable compensation to the employee, the employer must also decide how the employee’s estimated tax obligation will be addressed.
The biggest difference between a single-bonus and double-bonus arrangement is not the life insurance policy. It is how the employer chooses to address the employee’s tax obligation on the bonus and whether the employee receives the full intended value of the benefit.
The Employer Selects the Employee
An Executive Bonus Plan does not need to be offered to every employee.
The employer determines which employees will participate and the amount of the bonus each employee will receive.
This flexibility allows the business to tailor the plan to its objectives, budget, and key employee retention strategy.
The Employee Owns the Policy
The employee applies for and owns the life insurance policy. The employer provides the bonus, and the employee uses those funds to pay the policy premium.
Depending on the policy’s design, it may provide life insurance protection and the potential to accumulate cash value over time.
Because the employee owns the policy personally, the benefit may continue beyond employment, subject to the terms of any agreement between the employer and employee.
Single Bonus or Double Bonus?
For this example, both arrangements use the same assumptions:
- 45-year-old key employee
- $10,000 annual policy premium
- 22-year bonus period through age 67
- 24% assumed employee tax rate
The annual policy premium is the same in both examples. The difference is how the employer structures the bonus.
| Single Bonus | Double Bonus | |
|---|---|---|
| Planned Annual Premium | $10,000 | $10,000 |
| Annual Bonus | $10,000 | $13,158 |
| Estimated Tax on Bonus | $2,400 | $3,158 |
| Employee Out-of-Pocket Cost | $2,400 | $0 |
This example uses assumed tax rates for educational purposes only. Actual tax treatment depends on the employer’s and employee’s individual circumstances.
Your tax professional can explain how these rules apply to your specific situation.
How a Single Bonus Works
With a single-bonus arrangement, the employer provides a $10,000 bonus intended to fund the policy premium.
The employee uses the bonus to pay the premium but is generally responsible for the tax associated with that bonus.
Using the assumptions in this example, the employee would have an estimated out-of-pocket cost of $2,400.
How a Double Bonus Works
With a double-bonus arrangement, the employer provides an additional amount intended to help address the employee’s estimated tax obligation.
In this example, the employer provides a total annual bonus of $13,158. The employee uses $10,000 to pay the policy premium, while the remaining amount is intended to help cover the estimated tax on the total bonus.
Under the assumptions used in this example, the employee has no additional out-of-pocket cost.
Choosing the Right Structure
A single-bonus arrangement may appeal to an employer who wants to provide a meaningful benefit while controlling the annual cost of the plan.
A double-bonus arrangement may appeal to an employer who wants the employee to receive the full intended value of the benefit without using personal funds to address the estimated tax obligation.
Neither approach is inherently better. The appropriate structure depends on the employer’s objectives, available budget, and the experience the employer wants to create for the employee.
Structure Follows Objectives
Like every Executive Bonus Plan decision, the bonus structure should support the employer’s objectives.
The appropriate design depends on the importance of the employee, the available budget, and the goals the employer hopes to accomplish through the plan.
Next in the Executive Benefits Series
How Do I Maintain Control If the Employee Owns the Policy?
Employee ownership is one of the greatest strengths of an Executive Bonus Plan. But it also raises an important question for many business owners:
If the employee owns the policy, how do I protect my investment and encourage long-term retention?
In How a Restrictive Endorsement Agreement Works, we introduce the Restrictive Endorsement Agreement (REA) and explain how it helps answer that question.
Explore the Executive Benefits Series
- The Employee You Can’t Afford to Lose (Part 1)
- A Bonus That Builds an Asset (Part 2)
- How an Executive Bonus Plan Works (Part 3)
- How a Restrictive Endorsement Agreement Works (Part 4)
- Turning Today’s Bonus Into Tomorrow’s Retirement Income (Part 5)
- Is an Executive Bonus Plan Right for Your Business? (Part 6)
Let’s Talk
Wondering whether an Executive Bonus Plan fits your business? Let’s have a conversation about your objectives before discussing possible solutions.
Kurtz Lytle is the founder of IUL.Solutions, an independent insurance and retirement income practice based in Nashville, TN. All recommendations are made only after a full suitability review in accordance with each state’s insurance regulations. IUL.Solutions does not provide tax, legal, or investment advice. NPN #8993693.