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Executive bonus strategies

Employers may wish to encourage loyalty from their key employees and drive productivity and profitability. Executive bonus arrangements provide a key employee with a bonus used to fund a permanent life insurance policy:

  • The bonus is paid entirely with employer money.
  • The life insurance policy provides a death benefit for the key employee’s family, if the key employee dies while owning the life insurance.
  • The key employee may also withdraw the cash value upon retirement.

There are three common types of executive bonus strategies:

  1. Executive bonus arrangement
  2. Golden executive bonus arrangement (GEBA)
  3. Golden executive match (GEM)

Why choose an executive bonus strategy?

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Target employer

  • Wants to reward a select group of key executives
  • Wants to avoid plan administration
  • Is willing to give up control of the funding vehicle to enjoy current income tax deductibility
  • Needs current income tax deduction

In addition to a standard executive bonus strategy, a GEBA may be sought by a company that wants to:

  • Temporarily restrict how employee uses policy cash value
  • Potentially recover costs, if employee prematurely departs from the company

A golden executive match (GEM) solution may be sought by a company that needs a more cost-effective strategy to provide additional benefits to key employees. The employer provides a bonus to the executive in an amount that equals the tax on the income used to pay the premium on the life insurance policy.

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Target employee

All executive bonus arrangements:

  • Key executive
  • Highly compensated or management
  • Has life insurance need or supplemental retirement income need
  • Wants maximum control over funding vehicle
  • Willing to pay taxes today to achieve control of funding vehicle

GEBA

  • Must be a key non-owner employee
  • Maxing out all company sponsored retirement plans
  • Departure of this employee would significantly hurt business
  • Has inadequate insurance coverage
  • Wants a tax-advantaged funding vehicle to take withdrawals without penalty during retirement

GEM

  • Is able to or does not mind paying for premium out of pocket
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Features

In the event of the key employee’s death, the family receives an income tax-free death benefit.

Cash value from the life policy provides a source of supplemental retirement funds the employee can access in an income-tax-advantaged manner. This policy may also be part of an estate planning strategy.

GEBA

Can optionally establish obligations for the employee to fulfill before attaining full rights of ownership in the policy, allowing the employer to retain control over the arrangement.

GEM

A cost-effective alternative to golden executive bonus arrangements.

The employer may wish to apply some restrictions to the policy values to motivate employee loyalty. Under a GEBA, these restrictions may describe a vesting schedule for access to the policy cash value, or a repayment of premiums if the executive leaves the company before the vesting timeframe is complete.

How it works

Executive bonus strategy fundamentals

All executive bonus strategies have the same fundamental set up

  • Employee applies for a permanent life insurance policy and designates the beneficiary
  • Employer bonuses premium dollars to a key executive, or pays the premium directly to the insurance company (deductible for the employer)
  • The amount of the premium payment is included in the executive’s income

In addition to a standard executive bonus strategy, a GEBA may be ideal for a company that wants to:

  • Temporarily restrict how an employee uses policy cash value
  • Potentially recover costs if employee prematurely departs from the company
Executive bonus strategy fundamentals GEBA

A GEM may be sought by a company that needs a more cost-effective strategy to provide additional benefits to key employees. Under this solution, the employer provides a bonus to the executive in an amount that equals the tax on the income used to pay the premium on the life insurance policy.

Executive bonus strategy fundamentals GEM

Taxation

Employee income taxes

Premium payments are treated as compensation to the employee and are subject to income taxation. The premium payments must be reported on the employee’s W-2 form. At the employee’s death, the insurance proceeds are paid out income tax-free. If the employee surrenders the policy, the cash surrender value in excess of the cost of the contract is taxable as ordinary income to the employee.

Employer income taxes

The employer is allowed an income tax deduction for the full amount of the bonus in each year a bonus is paid. The premium payment is deductible as compensation to the employee provided:

  1. The employer is not directly or indirectly a beneficiary under the policy, and
  2. The premiums constitute additional reasonable compensation for services rendered by the employee.

To ensure the employer will be entitled to the income tax deduction, the arrangement must not allow the employer to be a direct or indirect beneficiary of the policy.

Therefore, the employer must not be entitled to receive any cash value from the policy, nor any portion of the death benefit. The insurance policy is used merely as an incentive for the employee to satisfy the separate employment agreement.

Social Security taxes

The premium payments are subject to Social Security taxes. The full amount of the premium payment will be subject to Social Security taxes, if the employee’s salary is below the Social Security taxable wage base.

Benefits and considerations for executive bonus strategies

Employer benefits

  • Little to no administration
  • Simple and flexible
  • Immediate income tax deduction
  • Selective participation
  • Not subject to employer-owned life insurance (EOLI) rules; avoids ERISA (For more information about ERISA, see the GEBA Foreword to Counsel and Specimen Documents)

Employee benefits

  • Cost-effective life insurance protection and choice of beneficiary
  • Immediate access to cash value, which can grow tax-deferred
  • Supplemental retirement income
  • Not subject to employer’s creditors
  • Estate planning aspects

GEBA

  • Provides for golden handcuffs
  • Potential recovery of costs if employee leaves

GEM

  • Cost-effective alternative to GEBA through employee payment of premiums

Employer considerations

  • No control over the policy
  • Does not receive policy’s death benefit or have access to cash value
  • Employer bears full cost of plan
  • No retention of asset or cost recovery if employee leaves unless GEBA is used
  • No golden handcuffs unless GEBA is used

Employee considerations

  • Must be acceptable underwriting
  • Death proceeds may be included in estate
  • Bonus is taxable income, but employer could pay tax cost via double bonus
  • Other limitations and considerations related to owning life insurance

GEBA

  • Golden handcuffs restrict access to cash value and loans of the policy

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Life insurance products contain fees, such as mortality and expense charges, (which may increase over time) and may contain restrictions, such as surrender periods.

Please keep in mind that the primary reason for purchasing life insurance is the death benefit.

Additional agreements may be available. Agreements may be subject to additional costs and restrictions. Agreements may not be available in all states or may exist under a different name in various states and may not be available in combination with other agreements.

Policy loans and withdrawals may create an adverse tax result in the event of lapse or policy surrender and will reduce both the surrender value and death benefit. Withdrawals may be subject to taxation within the first fifteen years of the contract. Clients should consult their tax advisor when considering taking a policy loan or withdrawal.

The Policy Design chosen may impact the tax status of the policy. If too much premium is paid, the policy could become a modified endowment contract (MEC). Distributions from a MEC may be taxable and if the taxpayer is under the age of 59 ½ may also be subject to an additional 10% penalty tax.    

An annuity is intended to be a long-term, tax-deferred retirement vehicle. Earnings are taxable as ordinary income when distributed, and if withdrawn before age 59½, may be subject to a 10% federal tax penalty. If the annuity will fund an IRA or other tax qualified plan, the tax deferral feature offers no additional value. Qualified distributions from a Roth IRA are generally excluded from gross income, but taxes and penalties may apply to non-qualified distributions. Please consult a tax advisor for specific information. There are charges and expenses associated with annuities, such as surrender charges (deferred sales charges) for early withdrawals.

This information may contain a general discussion of the relevant federal tax laws. It is not intended for, nor can it be used by any taxpayer for the purpose of avoiding federal tax penalties. This information is provided to support the promotion or marketing of ideas that may benefit a taxpayer. Taxpayers should seek the advice of their own tax and legal advisors regarding any tax and legal issues applicable to their specific circumstances.

For financial professional use only. Not for use with the public. This material may not be reproduced in any form where it is accessible to the general public.

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