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Split-dollar plans allow two or more parties to share the benefits—and costs—of a life insurance policy. These agreements are often between an employer and employee. Your employer can use it as a tool to recruit high-value executives, while you get the valuable perk of receiving life insurance. Here's a closer look at how these plans work.
How Does Split-Dollar Life Insurance Work?
Split-dollar life insurance isn't actually a type of insurance. It's an agreement where two or more parties share a permanent life insurance policy and split the costs and the benefits. One side usually buys the policy and pays for the premiums, and both sides get some of the death benefits when the insured passes away.
Businesses may include these contracts in executive compensation packages to attract top talent while also reducing the employer's risk of losing a high-value employee. If that employee dies suddenly, the business can use money from the death benefit to find a replacement and smooth the transition to new leadership.
On the private side, some individuals use versions of split-dollar agreements in estate planning.
With both options, split-dollar plans include three main elements:
- Who owns the policy
- How the benefits are split
- How payments are made
The agreement should also outline the period of coverage and how the policy can be terminated.
Types of Split-Dollar Life Insurance Policies
There are two types of split-dollar plans, and the key difference between them is the person who owns the policy.
Economic Benefit Arrangement
In an economic benefit arrangement, your employer owns and pays the premiums on a permanent life insurance policy. The employer controls the policy's cash value, names you the insured person and endorses a portion of the death benefit to your chosen beneficiary.
Because your employer owns the policy and pays the premiums, the life insurance is seen as an economic benefit to you and treated as a form of pay. So you'll pay taxes annually on the value of the death benefit beyond the amount your employer owns.
If you pass away while the agreement is active, the policy splits the death benefit between your employer and your beneficiaries based on the percentages or amounts that were previously agreed upon.
Loan Arrangement
With a loan arrangement, you own the policy while your employer lends you money to pay the premiums. You assign some of the benefits to the employer, and the policy acts as collateral. If you pass away while the policy is active, your employer receives a portion of the death benefit—usually equal to their contributions to the policy. The rest goes to your beneficiaries.
If you decide to leave the company or terminate the policy, you may have to pay back all the money loaned to you depending on the terms of the arrangement. This is often paid back using the cash value of your policy. You may keep any remaining benefit since you own the policy.
Under this arrangement, the employer must charge interest. You won't pay taxes on the loan as long as the rate complies with the applicable federal rate, or AFR.
Benefits of Split-Dollar Insurance Plans
Split-dollar insurance plans can be a good option for both the employer and employee. Some of the benefits include:
- Cost sharing: For split-dollar plans where the employer owns the policy, they'll often pay for the premiums. But they may split the costs with you in some situations.
- Payout for both parties: Depending on the agreement, both the employer and the insured's beneficiaries receive a portion of the death benefit. The person who pays the premiums may also recoup their costs.
- Low interest rates: In the loan arrangement, the employer must charge interest on the loan to the employee. But the employer usually uses the minimum below-market rate.
- Valuable compensation benefit: Employers that offer split-dollar plans in their executive compensation packages may be able to more easily recruit and retain top talent. The employee receives valuable life insurance, which may increase loyalty.
How Are Split-Dollar Plans Terminated?
Split-dollar plans may be terminated in a few different ways. Here are the most common scenarios:
- The employee dies while the agreement is active. Depending on the terms of the agreement, the employer would recover the policy's cash value, the premiums they paid or the outstanding loan amount. The employee's designated beneficiaries receive the rest as a tax-free death benefit.
- The agreement terms end. In a loan arrangement, the policy will no longer act as collateral. Under the economic benefit plan, the policy may be transferred to the employee. This would generate taxable income to the employee, which the employer may be able to deduct as a business expense.
- The employee leaves the company. If you leave the company, you'll use the cash value to repay the employer for premiums they covered. You'll keep the rest.
Frequently Asked Questions
Taxes on a split-dollar plan largely depend on who owns the policy.
- Loan arrangement: You own the life insurance policy, and your employer lends you money to cover the premiums and charges interest on the loan.
- Economic benefit arrangement: Your employer owns the policy, which is considered an economic benefit for you. So you'll pay taxes on the value of the life insurance policy and the cash value portion that's assigned to you.
One person (or entity) usually owns the policy while both sides receive some benefit. In a business setting, the employer may own the policy and pay the premiums. Or the employee may own the policy and pay the premiums using borrowed money from the employer.
Split-dollar plans were designed to help companies reduce the risk of losing high-value employees. But some individuals use them for estate planning purposes as well, sometimes to avoid triggering estate taxes.
The Bottom Line
A split-dollar life insurance plan could be a valuable benefit for everyone involved. But these agreements may get complicated, and you should understand the tax implications before agreeing to one.
Your employer also might not offer these. But if you're interested in buying your own type of coverage, you can check out life insurance plans and compare your options.