You’ve found the perfect person for a key position in your business. Now, how do you put together a compensation package attractive enough to close the deal?
Ideally, one that goes above and beyond the usual offerings, but that isn’t too hard on your bottom line? One program worth looking at is an executive bonus plan (sometimes called a Section 162 plan).
How a Section 162 bonus plan works
A Section 162 executive bonus plan is a way to attract, reward, and retain key employees using life insurance. (Calculator: The cost of losing a key employee)
Here’s how a Section 162 bonus plan works: The employer takes out a life insurance policy on a key employee. Sometimes it’s a term policy, meaning that the policy is only in effect for a set period of time, and doesn’t build cash value. Usually, though, it’s a permanent policy (either whole life or universal) that accrues value over time.
The employee is the owner of the policy, and gets to determine the beneficiaries and manage the funds within the policy. The employer covers the cost of the policy by periodically giving the employee a bonus big enough to pay the policy premiums. The employee then pays the premiums to the insurance carrier.
When the employee reaches retirement age — or sooner, depending on how the arrangement is set up — they can access the cash value of the policy for extra income if they want. If the employee dies, the death benefit of the policy would go to their family or other named beneficiaries.1
Set it up the way you want
One nice thing about a Section 162 bonus plan is that it can be structured in a number of different ways, depending on what makes the most sense for your company and what your goals are with regard to the key employee. A financial professional can tell you more about the various options, but here are a few examples:
Reward the key employee for their loyalty: You can set up a vesting arrangement, restricting their access to the cash value of the policy until predetermined dates, or until they reach retirement. So the plan becomes a form of “golden handcuffs,” designed to keep the employee working at your company for as long as possible.
Tie the plan to performance: If the employee doesn’t achieve certain goals or benchmarks, you can decrease or withhold the bonus amount.
“Double bonus” the employee: The bonus you pay the employee is considered taxable income, so if you’re feeling extra generous, you can bonus them enough to cover both the premium and any taxes they’ll owe.
What’s in it for you?
Because you’re bonusing the employee to cover the insurance policy premiums instead of paying the insurance carrier directly, the bonus amount is generally considered “reasonable compensation.” So it’s tax-deductible, just like a straight-up cash bonus would be, but what you’re providing has greater long-term value to the employee. (Related: 3 tax advantages of life insurance)
The only major downside to an insurance-based Section 162 bonus plan is that when the employee leaves the company, the policy goes with him or her. You’re no longer obligated to pay the premiums, of course, but you also don’t recoup any of the value of the policy you’ve been paying for.
And, of course, it’s worth keeping in mind that an executive bonus plan isn’t going to be the perfect fit in every situation. The person you’re trying to woo has to want life insurance in the first place.
Add it to your compensation toolbox
Reeling in and keeping a key employee can yield major returns for your business. But different employees are lured by different kinds of rewards, depending on their personal and financial circumstances. A Section 162 executive bonus plan is a simple, flexible strategy to have in your back pocket in case the right candidate for it comes along.
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This article was originally published in August 2017. It has been updated.
1Distributions under the policy (including cash dividends and partial/full surrenders) are not subject to taxation up to the amount paid into the policy (cost basis). If the policy is a Modified Endowment Contract, policy loans and/or distributions are taxable to the extent of gain and are subject to a 10% tax penalty. Access to cash values through borrowing or partial surrenders will reduce the policy's cash value and death benefit, increase the chance the policy will lapse, and may result in a tax liability if the policy terminates before the death of the insured.