Some experts warn that the improving economy may create a surge of talent flight – just when employers will need their key people the most. As a precaution, many employers are turning to innovative benefits programs for help in keeping their top employees in place, focused and motivated.
In the past, some businesses have filled such requirements using nonqualified deferred compensation (NQDC) arrangements funded with corporate-owned life insurance (COLI). These arrangements have long been popular with key employees due to their tax-deferral features, but they’ve become harder for employers to administer since Section 409A of the IRS Code went into effect in 2005 – and penalties for getting it wrong are severe. Meanwhile, uncertainty about future income tax rates has raised new questions about the relative advantages of paying taxes now or later.
Benefits to employers
As a result of these trends, we are seeing the emergence of a new model for key employee retention: self-owned life insurance. This model is different from COLI in that the employee owns the policy, rather than the employer. The company can pay for all or some of the annual premiums, which can be tax-deductible for the employer. The self-owned model may benefit a business in several ways:
• Selectivity in funding: Employers can account for employees’ relative criticality by adjusting who they select for participation and how they fund the program.
• Immediate tax deduction: Premium payments made by the employer come right off the top line as a deductible expense, provided that the key employee’s compensation is reasonable overall.
• Flexible incentive structure: The employer can structure the self-owned life insurance in concert with an agreement that the executive will get certain related incentives by remaining with the company for a defined time period.
• No future funding obligations: Generally, the employer has no obligation to fund the self-owned life insurance in the future. This is unlike typical NQDC arrangements, in which the employer is obligated to pay promised retirement benefits 20 or 30 years down the road.
Policy loan eases
income tax burden
For the key employee entering a self-owned life-insurance arrangement, the biggest potential hurdle may be income taxes. This is because any premium payments made by the employer into the key employee’s policy are taxable to the recipient in the current tax year. The employee typically might cover these taxes from savings. In some cases, he or she might take a loan from the insurance policy to pay the taxes; but if the policy is a typical indexed universal life loan, they would lose the potential for additional interest credited based, in part, on market index performance.
New loan features now on the market and available in certain indexed universal-life products can provide the key employee with a potentially more advantageous course. This new type of loan lets the employee borrow the funds needed to satisfy their income tax liability but allows any net premium to have the potential for additional interest credited based, in part, on market index performance. This lets the employee potentially leverage the difference between the loan’s charged interest rate and the crediting rate of the elected strategies. The employee can pay the interest due on the policy loan annually or allow the interest to be added to the policy loan amount.
With this approach the net premium in the policy is at work – with potential interest crediting based, in part, on market index performance or, at the least, protected from downside risk by a guaranteed minimum annual interest rate. However, this potential must be balanced against the interest rate charged on the policy loan.
Benefits to owners
If a business is structured as a tax pass-through entity (i.e., S corporation), the business owner usually cannot get as much personal benefit from typical qualified plans because of IRS restrictions. But with a self-funded, life-insurance arrangement, it’s a different story.
Most such owners take their cash flow out of the business in two ways. First, they take a portion in wages because these are deductible to the extent they are reasonable. Then, they take the balance as taxable distributions because they can save the payroll taxes on this portion.
Also, when they need to pay their taxes (quarterly or annually), they may borrow the amount needed from the insurance policy through a policy loan.
A powerful tool
Self-owned, life-insurance arrangements are well-suited to today’s dynamic economic times. They can help business leaders to keep top talent in place, while offering selectivity and flexibility in funding. And they offer top employees – even business owners themselves, in some cases – a powerful new resource that may help provide for financial protection in the short term and for pursuing greater retirement security in the years to come. •
Peter L. McCarthy is a senior advanced sales consultant for ING U.S. Insurance.
