Executive Bonus Plans result in compensation includable in the executive’s current income. However, once the funds are paid to the life insurance policy as a premium, they have growth potential and can be accessed without additional taxation1. This treatment is contingent upon the policy remaining in-force until death and avoiding a modified endowment contract (“MEC”) designation through mortality2.
Because the payments are includable in the executive’s taxable income each year, these plans are rarely subject to vesting requirements. This lack of vesting affects the value of the plan from a retention perspective3. That is, it only incentivizes year-to-year or short-term retention. While these plans could be funded in a lump sum at implementation, they are typically funded over a defined period.
How It Works
The organization pays a bonus to the executive with the after-tax proceeds used to purchase a life insurance policy owned by and insuring the executive’s life. Most of the time, the life insurance policy is designed to efficiently accumulate cash value that the executive can access at retirement or another point in the future.
From the organization’s perspective, payments made as premiums to the life insurance policy will be a compensation expense and will not be recovered. The executive will own the life insurance policy and enjoy all its benefits.
Income (the bonuses that ultimately result in premiums) is taxed when received, but the policy provides tax-deferred growth and access to the policy’s cash value in the future. In addition to the death benefit available for the executive’s beneficiaries, the executive’s access to the policy’s value through life insurance policy loans is not includable in income so long as the life insurance policy does not lapse. There are typically no restrictions, aside from any restrictive endorsements, on the executive’s ability to access policy values.
- Retention Value
- Timing and Amount of Capital Requirements
- Impact on Financial Statements
- Plan Administration Requirements
- Regulatory Environment
- Through life insurance policy loans. Subject to limitations, organization and executive should review the life insurance illustrations for details.
- A Modified Endowment Contract (“MEC”) is a tax qualification of a life insurance policy whose cumulative premiums exceed federal tax law limits. In a MEC, distributions of cash value lose their tax-advantaged status.
- In some cases restrictive endorsements can be added to the life insurance policy as a way to limit access to policy value and add to plan’s retention value.