What Is a Split-Dollar Life Insurance Plan and How Does It Work?

A split-dollar life insurance plan is a valuable arrangement that you might want to consider. The life insurance plan shares policy costs and proceeds. How does a split-dollar life insurance plan work? What types of split-dollar plans are available?

A major concern for many people is plunging their households into financial hardship when they die. Purchasing a life insurance policy can help avert that problem. If you hold a critical role at the company you work for, the company might want to retain you for as long as possible. In that case, the company might chip in to help secure your family's financial future when you pass away and a split-dollar contract would come into play.

A split-dollar plan is a joint venture approach to life insurance coverage. It involves two or more parties agreeing to share the cost and benefits of a life insurance policy. Think about you and a partner teaming up to contribute toward paying insurance premiums and then splitting the proceeds when the policy matures. In this case, the proceeds would go to your beneficiary.

This type of arrangement can be between a company and its employee, a company and its shareholders, or between individuals. When the plan is between individuals, it’s called a private split-dollar life insurance plan. The most common split-dollar arrangement is between a company and its employee.

Companies use split-dollar life insurance plans to encourage good workers to stick with them for the longest period possible. The plan is usually built into executive compensation packages.

The arrangement usually works with permanent life insurance policies with cash value, like whole life insurance and universal life insurance. The cash value means that the policy comes with an investment component. As a result, part of the premiums you pay goes into funding the death benefits that the beneficiary would receive upon your death.

A small portion of the premiums goes into a cash-value account. The funds in the cash-value account might be available for you to withdraw or borrow against when you’re still alive.

If you enter into a split-dollar insurance contract with your company, you might own the policy while the company pays the premiums. When you pass away, the policy proceeds are released to your beneficiary and the company might take a cut of it, especially if the arrangement involved a loan structure.

In a split-dollar contract, details are outlined like who owns the policy, who pays the premiums, and how the benefits are split. The arrangement can be structured in a variety of ways, which leads to different tax treatments.

When you own the policy but the company pays for it, the contract becomes a collateral assignment using a loan structure. The IRS treats it as if the company lends you interest-free money to pay for the premiums.

When the company owns the policy and pays the premium but assigns the benefits to you, the contract becomes an endorsement agreement with an economic benefit structure. In this case, you would be taxed on the value of the policy.

The split-dollar life insurance contract falls under non-qualified plans. As a result, the companies that offer it have to fund the plan with after-tax dollars. In the early 2000s, the IRS updated its rules regarding split-dollar plans to close a potential tax loophole.

However, there's a great tax minimizing opportunity with a split-dollar plan. You can set up an irrevocable life insurance trust as the beneficiary of the policy, in which case the benefits won’t be subject to estate tax when you pass away.