Split-Dollar Life Insurance Explained
Split-dollar life insurance can be a valuable benefit and estate planning tool. Here's what you need to know.
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Split-dollar life insurance isn’t a type of insurance. Rather, it is an agreement between two parties to share the costs and benefits of a permanent life insurance policy.
Often, the agreements are between an employee and an employer, with the split-dollar plan showing up in an executive compensation package. These packages became less common after a change in their tax treatment in 2003, according to the Legal Information Institute.
While you may not be offered a split-dollar life insurance benefit anymore, wealthier Americans use private versions in estate planning. There are still tax benefits to be had, if you’re willing to jump through some financial hoops.
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What is split-dollar life insurance?
In some ways, split-dollar life insurance is a simple idea. The business pays for life insurance while you’re working and you get the benefits without the upfront payments. The complicated part is in how everything is structured and taxed.
With split-dollar life insurance, there are three decisions to make:
Who will own the policy.
How the benefits will be divided.
How payments are made.
There are many ways to carve up a split-dollar agreement, but two stand out.
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When you own the policy
When you own the life insurance, but your employer makes the premium payments, the system is called a collateral assignment using the loan regime.
“Collateral assignment” means the policy belongs to you, but some of its benefits are assigned to your employer. The employer then lends you money to pay the life insurance premiums without worrying about not getting repaid — the signed-over portion acts as collateral for the loan. If you die or leave the company, the benefits signed over to your employer will kick in, ensuring the company is repaid, or the employer can forgive the loan.
“Loan regime” is an IRS term summarizing the way these agreements are taxed. Since the employer is lending you money, you need to pay some interest to your employer on the amount borrowed. Otherwise, it would just be a free, untaxed benefit. The amount of tax you’ll owe depends on the interest rate your employer charges you.
This option is unavailable to publicly traded companies, as the Sarbanes-Oxley Act prohibits these businesses from lending money to their executive employees.
When your employer owns the policy
When your employer owns the policy, but you get the benefits, the arrangement is called an endorsement agreement using the economic benefit regime.
“Endorsement agreement” means your employer keeps ownership of the policy. The employer will then allow you to designate the life insurance beneficiary. However, the employer may have access to the policy's cash value.
“Economic benefit” refers to how the IRS treats this type of split-dollar insurance agreement. It means your employer is giving you some benefit but not a loan. That means you’ll be taxed on the value of the life insurance provided, and that value is determined by the IRS or the insurance company.
Split-dollar life insurance for employees
Split-dollar agreements offer plenty of benefits for employees. Extra life insurance coverage can be a boon, especially for high earners who are more likely to be offered these sorts of agreements by their employers.
In addition to coverage, you may get access to the cash value of the life insurance — and the taxes associated with it. This cash value is money you may be able to withdraw or borrow against later in life or in retirement. Each policy is structured differently, and your employer will provide you with more details on what benefits you’ll have.
Collateral assignment is the more popular version of split-dollar life insurance. Here, you’ll own the policy and make payments with loans from your employer. The IRS treats each premium payment as a new loan, which can make accounting a little complex.
In general, split-dollar life insurance tax treatment is messy. The IRS developed rules for split-dollar agreements to try to close loopholes, but that meant determining a list of ways companies could treat the agreements. With fewer buckets in which to fit all these arrangements, more complex work has to be done in their structuring and execution to make them fit.
Due to the complexity, it’s important to work with a qualified insurance agent or fee-based life insurance consultant as well as a tax advisor who are all familiar with split-dollar life insurance.
Split-dollar life insurance in estate planning
Split-dollar life insurance isn’t just a feature of employee benefit plans. Wealthy individuals can also form agreements called private split-dollar life insurance arrangements. These private arrangements often involve an irrevocable life insurance trust, or an ILIT.
ILITs are ways for you to put your life insurance benefits in the care of a tax-advantaged trust in exchange for less future control. You’re basically locking up anything in the trust out of your own reach — that’s what the “irrevocable” part implies. The main benefit of an ILIT is that it won’t be included in your estate, escaping estate taxes.
For most people, this doesn’t matter. Estate taxes apply only to the very wealthy. For 2024, federal estate taxes kick in when a person’s assets at death exceed $13.61 million.
Anyone considering split-dollar life insurance in their estate planning should talk to a tax advisor along with a fee-based life insurance consultant specializing in this area.
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