Over the past twenty years, numerous tax law changes have reduced personal income tax rates to the lowest marginal rates in over fifty years. At the same time, additional restrictions and reporting requirements have been imposed on tax-qualified retirement plans, making them increasingly unattractive for key employees. These changes have led to the widespread implementation of executive benefit plans utilizing specially designed life insurance policies for companies of all sizes.
One type of executive benefit plan, a Section 162 Executive Bonus with Restrictive Endorsement (aka REBAs), are growing in popularity with employees and executives who want to accumulate more money for the future. For employers, REBAs can attract, retain and reward top talent in a competitive employment market.
The Cowart Group helps its corporate clients attract, retain and reward key executives through the use of flexible and individually designed executive benefit solutions.
What is a REBA?
While many life insurance policies are purchased by individuals, it is possible for an employer to set up a bonus plan that is designed to pay insurance premiums for key employees. Such bonuses are immediately deductible to the employer and, if structured properly, retirement and death benefits can be received by the employee free of federal income tax.
Here is how a REBA works:
An employer makes a cash bonus to an employee which is used to fund a cash value life insurance policy on the life of the employee. The employee maintains all rights to the policy and can use the policy’s cash values to supplement future income while the employee is working or retired. Under most circumstances, the employee accesses a policy through loans which are tax-free as long as the policy remains in-force during the employee’s lifetime.
In addition, the employee is able to name a beneficiary of their choice to receive the policy’s income tax-free death benefit. Typically, the policy is designed to provide the minimum amount of death benefit cover permitted by regulations so that tax-free cash value growth within the policy is maximized. If the policy is large enough, the employee may wish to have an irrevocable life insurance trust (ILIT) own the policy so that the value of the policy’s death benefit is not included in the employee’s estate when they die. The trustee is able to make decisions regarding access to the policy for cash in the future.
Employer
From an employer’s perspective, a REBA is simple and easy to implement and administer. The bonus payments are deductible to the company and taxable to the employee just like most forms of cash compensation. In order to retain a plan participant, the employer can ask the employee to sign an agreement pertaining to certain restrictions. The employer may require a restrictive endorsement to the policy which requires the employer’s consent if the employee wants to surrender the policy or access the cash value of the policy before a certain date or period of continued employment. For example, a 5-year restriction is common, and vesting may be designed to be a “cliff”, where the employee is restricted from accessing all of the bonussed amounts until the restriction ends, or a “step” where the restriction is lifted gradually over the endorsement period.
Under most designs, executive bonus plans are not subject to ERISA and are typically not subject to the same complex rules of other nonqualified deferred compensation plans. Employers may discriminate which employees to include in a plan as well as the amount, timing and conditions for the bonus and the terms to any restrictions.
Employee
From an employee’s perspective, an executive bonus plan allows the employee to save more than the limits of any qualified plan. Outside of any employer restrictions for short-term access, the employee is free to access or not access the policy’s cash values whenever they would like. There is also an element of portability to a plan since the employee owns the policy. An employee may ask a future employer to continue funding the policy through another bonus arrangement.
As noted, the bonus is taxable to the employee as a wage and, as a wage, the bonus is subject to both FICA and FUCA withholding. In some REBAs, the employer may elect to carry out a ‘double bonus’ and provide the employee with a bonus large enough to pay the life insurance premium as well as the income taxes incurred by the employee on the bonus. Essentially, through a double bonus, the employer eliminates any out-of-pocket expense for the employee.
In this way, a REBA acts as the ultimate ROTH IRA for a participate with ‘tax-free’ contributions (via a double bonus) and tax-free distributions from the policy (via a combination of loans and withdrawals).
See It In Action
Madison – Our Sample Case
Madison is a single, 38-year-old senior manager with Baylor Logistics, LLC. Baylor Logistics agrees to a REBA that provides Madison with a double bonus, or gross-up bonus, so that Madison will not have any out-of-pocket expense or tax liability by participating in the plan. Madison uses the bonus to purchase a cash value index universal life policy on her life with an annual contribution of $40,000.
Baylor Logistics is able to take a tax-deduction equal to the amount of the entire bonus.
Madison and her employer agree in writing that Madison cannot access the policy’s cash values for five years. Further, if Madison leaves the company within five years, she must repay all of the bonuses given under the plan.
At age 62, Madison retires from Baylor Logistics to work part-time for a non-profit. The index universal life policy now has $1,950,000 in cash value which Madison elects to access via tax-free policy loans to supplement her income.[1]
Advantages of 162 Executive Bonus Plans with Restrictive Endorsements
- The employer may selectively choose the employees they wish to include.
- The bonus payments are fully tax deductible to the employer.
- An executive bonus plan is simple and easy to implement.
- Executive bonus plans are not subject to the limits of qualified plans.
- Participants can have immediate access to the policy’s cash value unless there is a restricted or controlled arrangement with the employer.
- The employee is free to name the beneficiary to the policy’s income tax-free death benefit.
The executive benefit experts at The Cowart Group will advise an employer on how to structure a REBA so that it is mutually beneficial for both parties.
Choosing An Executive Benefit to Stay Competitive
In today’s labor market, companies are turning to executive benefit programs to attract, retain and reward key talent. Navigating the options available, choosing and designing the best solution, and implementing it is where The Cowart Group can help. With a focus on protection, savings and long-term growth, The Cowart Group’s compensation solutions are designed to safeguard both business and personal interests and deliver first-class customer service.
[1] Assumes an annual 5% rate of return after policy expenses are deducted.
