In our last article, we introduced group term life insurance plans and how any employer, large or small, could implement this as a means of providing benefits to employees. We discussed advantages and disadvantages under these group term plans, particularly how such plans do not offer much flexibility in providing additional benefits for key employees.
We then discussed the group carve-out option as a potential solution for employers who wish to provide additional incentives and benefits for the employees in leadership positions or those who have been with the company for many years. These group carve-out plans are separate from the group term coverage the other employees of a given company enjoys, and do not impact the benefits under typical group term plans.
In this article, we will dig deeper into the carve-out option, discussing the mechanics of such plans and the many options available to employers.
How do Group Carve-Out Plans Work?
As mentioned in part one of this article series, a group carve-out plan is a way for employers to reward key employees over and above what is available through a group term life insurance plan. A carve-out does not affect the other employees’ access to these group term benefits. Key employees can enjoy substantial life insurance benefits that may increase in cash value over time. And, employers enjoy better cost efficiency than through a group term plan.
By carving out key employees from the pool covered under a group term plan, the employer is both rewarding them as well as improving retention of these employees. Key employees can include those who have been with the company for many years, executives, team leaders, and managers, among others – the possibilities are limitless on the part of the employer.
Let’s take a look at an example of a carve-out plan in action and how it saves the employee substantial taxes. In the example, before the carve-out occurs, the key employee has $250,000 in group term life insurance coverage. $200,000 of that coverage is taxed as “imputed income” by the federal government. That can be quite a severe tax hit.
After the carve-out, the key employee still has $50,000 in group term coverage, which is capped at that level to avoid imputed income and the tax penalties that are associated with it.
The remainder of the coverage is provided by an individual life insurance policy funded by the employer, growing in cash value over time. This benefits both the employee and employer, helping to save money in taxes and administration while offering supplementation for retirement income.
Carve-Out Plan Design Options for Employers
Now that we understand how carve-out plans work and how they benefit both employee and employer, it can be useful to understand the three most popular design options for these valuable plans. Each of the three design options have advantages and drawbacks.
Executive Bonus Plan:
The first design option is the Executive Bonus Plan. In this option, the employee benefit is maximized and is the easiest type of carve-out plan to put into place. It also retains tax deductibility of employer-paid premiums, helping to save money.
Advantages of this option are:
- Premiums on life insurance plans are tax-deductible by the company offering the plan to their key employees.
- The employee owns the policy, giving them maximum control over it.
- The employee can accumulate cash value in the plan, helping to supplement other sources of retirement income.
Of course, there are some disadvantages to the Executive Bonus Plan. These are:
- Premiums paid to the plan are considered taxable income on the employee’s part.
- There is no ability for cost recovery by the employer.
- There are fewer incentives for key employees to remain with their company with this design option, as the employee owns the policy. This idea of retention incentives is sometimes referred to as the “golden handcuffs effect”.
Death Benefit Only Plan:
The next design option is the Death Benefit Only Plan, which keeps control over the plan in the employer’s hands and provides substantial benefits to employees who are selected to participate.
The advantages of this option are:
- Cash values of the policies are held by the employer.
- Any benefits paid to employees are tax-deductible on the part of the employer.
- Death proceeds are also received tax-free by the employer.
- This plan has a substantial golden handcuffs effect, helping to retain valuable employees.
Disadvantages of the Death Benefits Only Plan include:
- Employer premium payments are not considered tax-deductible.
- Benefits that the employee’s beneficiary or beneficiaries receive are taxed as income.
- The employee has no portability, should he or she choose to change employers.
- The business itself must have continuity for the benefits to be paid if an employee should die unexpectedly.
Endorsement Split Dollar Plan:
In this design option, the employee can receive substantial benefits from a permanent life insurance policy, but only at the cost of group term insurance. This represents incredible savings in many cases.
Advantages of the Endorsement Split Dollar Plan include:
- Tweaking the plan can result in little or no income tax implications on the part of the employee.
- Employers enjoy cost-recovery options.
- There is a moderate golden handcuffs effect, serving to help retain valuable employees.
The drawbacks of this plan design option include:
- Premium payments made by the employer are not tax-deductible.
- Sizeable cash amounts may be needed by the employee to acquire the employer’s rights to the policy (in cases of an employee “buy out”.
- Any reportable economic benefits increase each year, and will continue to do so until and unless the plan is terminated.
An Action Plan Checklist for Carve-Out Plans
Carve-out plans can be a great way for employers to reward their key employees with benefits that exceed those found in group term insurance plans. To get started, a checklist can be a valuable tool for employers, and is broken down into action items that must be done immediately as well as in the short and long terms:
- Choose the key employees to participate in the carve-out plan.
- Select the design option that suits both employer and employee needs.
- Choose the life insurance funding policy or policies.
- Draft plan agreements and corporate resolutions authorizing the plan as needed.
- Implement these agreements and resolutions.
- Review the issued policy or policies to ensure that all arrangement are appropriate.
- Review the plan annually, both for performance as well as to ensure it still meets employer and employee needs.
- During the review, the leadership team should evaluate other employee benefit plans. This can help to identify areas where employee retention is optimized as well as to identify new key employees to take part in carve-out plans or other benefits packages.
If you need help with carve-out plans, contact Geoff today.