While there is no requirement that a deferred compensation plan be funded with insurance, many plans do — and for good reason.  A number of important tax and other benefits can be realized when life insurance is used as the funding mechanism for a deferred compensation plan. Life insurance is ideal for ensuring that the promised benefits of a deferred compensation plan will be available when necessary.

Few organizations would be willing to commit themselves to pay a preretirement survivor death benefit that might amount to hundreds of thousands of dollars — and which might be payable only moments after the deferred compensation plan agreement is signed. Life insurance gives the employer the funds needed to meet its obligation to the executive's estate or heirs. For a fraction of the sum insured, the employer can receive the insurance proceeds at the executive's death — free of tax — to meet its obligations to the executive's family. Furthermore, life insurance enables the employer to recover some or all of the costs of the plan, regardless of whether the benefits are paid to the survivor or to the employee as additional retirement funds.

For executives who are insurable, funding the deferred compensation plan with insurance is the more effective means of fulfilling the employer's promise of benefits.

Matching Asset for Substantial Corporate Liability

As noted earlier, the life insurance policy or policies have no direct relationship to the deferred compensation agreement. In fact, a deferred compensation agreement could be carried out regardless of whether or not there is life insurance or any other employer-reserved asset involved. The purpose of the life insurance is to strengthen the corporation's overall financial picture and to facilitate its cost recovery.

Although the life insurance is designed to strengthen the employer's current and future financial picture, it impacts the employee as well. The existence of life insurance as an informal funding medium means greater peace of mind for the employee who realizes that the employer has created a matching asset for the substantial corporate liability imposed by the deferred compensation agreement.

Type of Policy

The particular type of policy used within the deferred compensation agreement depends on the general financial situation of the corporation and the ages of the prospective insureds. A cash value policy, preferably a whole life, universal life or variable life policy, is usually recommended. Using a life insurance policy that builds cash values permits the employer to make the decision at the employee's retirement as to whether to make the promised payments out of current earnings or from the policy's cash value.

Universal life insurance — whether of the declared rate, equity index or variable variety — can be particularly useful in a deferred compensation plan because of the policy's flexibility. The premium flexibility that is a hallmark of universal life insurance plans makes the use of permanent life insurance a more attractive funding option to employers whose cash flow may be less stable or seasonal. Knowing that a premium payment may be deferred or skipped altogether often is reassuring to these employers. In addition, the employer's ability to fully fund the benefit during the employee's working years may be important to many employers.

Policy Application and Ownership

The employer should apply for the insurance. We have noted previously that the employer should be the beneficiary, as well as the owner of all incidents of ownership in the policy. If the employee's spouse is made the policy beneficiary, or if the proceeds are made payable to a trust to be held for the benefit of the insured's family, the premiums the employer paid may be taxed in the current tax year as additional compensation to the insured.

It is equally important that when an attorney drafts the deferred compensation agreement, there are no provisions giving the employee any rights to the insurance policy, either during the employee's service with the employer or upon his or her retirement.

Employer Can Recover Its Costs

From the employer's point of view, the use of life and disability income insurance means that the business will be in a sounder financial position to:

pay benefits to a retired or disabled employee; or
make payments to a widow or widower in those cases in which survivor benefits are included under the plan.

In addition, life insurance may permit the employer to recover its costs of paying the benefits as well as its premium costs.

Accessing Policy Values

It is not the premium flexibility — though it is important — that makes universal life insurance so applicable to its use in deferred compensation plans, however. The more important flexibility of universal life insurance for deferred compensation plan purposes relates to the employer's ability to access policy values through cash value withdrawals and policy loans.

As we have discussed, an important feature of deferred compensation plans is the employer's ability to recover some or all of its costs. By maximizing the employer's ability to access policy values through both withdrawals and policy loans, there may be no need to surrender the life insurance to provide cash to pay the benefit. Because of that, the employer can obtain the funds needed to pay the promised deferred compensation benefit and retain much of the life insurance death benefit that the employer needs to recover its costs.

 Handling the Policy at Retirement
When the employee reaches retirement age, ownership of the insurance policy should, nonetheless, remain in the employer. If the policy or any of the incidents of ownership are transferred or assigned to the insured employee, the fair market value of the policy at the time of transfer would constitute income and be taxable to the employee in the taxable year that the transfer was carried out.

There are two approaches that an employer may take with respect to the life insurance policy at the time of the employee's retirement. The employer may:

maintain the policy in force; or
surrender the policy.

Keeping the Policy in Force

In many cases, the employer will choose to continue the life insurance policy in force beyond the employee's retirement date to recover its plan costs and avoid the income tax liability on any cash value received in excess of aggregate premiums.

If the employer maintains the coverage beyond the point at which deferred compensation benefits start to become payable to the employee, the important question may become one of where the funds come from to pay those benefits. The answer is that the funds needed to pay the deferred compensation retirement benefits can come from:

cash value withdrawals and policy loans; or
current employer funds.

Using current funds, the employer keeps the policy in force with a death benefit that is undiminished by withdrawals or loans. In fact, the death benefit may continue to increase as the cash value increases even if the employer ceases policy premium payment. As a result, the employer will maximize the tax-free death benefit it receives at the employee's eventual death.

However, for the employer who wishes to avoid making deferred compensation retirement payments from current income, the policy cash value provides some welcome relief.   Before examining the use of cash values, let's consider the two factors that favor the employer's use of these values, the:

FIFO tax treatment of policy withdrawals; and
income tax deductibility of benefit payments.

FIFO  —Tax-Free Withdrawals of Cost Basis

In a deferred compensation plan, the life insurance policy used to informally fund the plan has a cost basis that generally is equal to the cumulative premiums paid for the policy. So, provided the life insurance policy is not a modified endowment contract (MEC), the employer may withdraw the amount of cash needed to pay the benefit from the cash value without incurring tax liability until the total withdrawal exceeds the employer's total premiums.  In short, the current federal income tax law permits a life insurance policyowner to withdraw funds from a non-MEC life insurance policy tax free up to the policyowner's cost basis.

Modified Endowment Contract

A life insurance policy is deemed a modified endowment contract (MEC) if the accumulated premium amounts the policyowner paid under the contract during the first seven policy years exceed the sum of the net level premiums that would have been required (on or before such time) if the contract provided for paid-up future benefits after seven level annual premiums.

If the life insurance policy is an MEC, the tax treatment is LIFO (last-in, first-out), and the gain is deemed to be withdrawn first.

Benefit Payments Are Deductible

Any retirement benefit payments made by the employer under a deferred compensation agreement are income tax deductible.

For example

Assume that the employer is a corporation that has a taxable income in excess of $75,000. As a result, it is in a 34 percent federal income tax bracket.

If the employer makes a tax deductible deferred compensation payment of $2,500 each month, that payment has an after-tax cost of only $1,650. Each time the employer makes a $2,500 payment to the deferred compensation plan participant, it reduces its federal income tax liability by $850. ($2,500 × 34% = $850).  For that reason, a tax-free cash value withdrawal of $1,650 is all that is required to fund the deferred compensation payment. The balance of the retirement payment comes from the employer's tax relief.

Generally, the employer will also be subject to state income taxes, and these deferred compensation payments also will lower its state income tax liability.

Switch to Policy Loans

Withdrawals of cash value can be taken, without tax consequence, up to the policy's cost basis (the accumulated premiums paid on the policy).  At some point, however, assuming that the employee is sufficiently long lived, the employer will have taken cash value withdrawals from the life insurance policy equal to its cost basis. Any further withdrawals will result in an income-taxable distribution.

At the point that the employer's total cash withdrawals equals its cost basis, the employer may continue to enjoy the receipt of tax-free funds by switching from withdrawals to policy loans. The amount of policy loan required to make the deferred compensation payment is the same as the amount that was required as a cash value withdrawal. Specifically, it is the amount that results when the total deferred compensation payment is multiplied by 1 minus the employer's income tax bracket. [In the example above: (1.00 minus .34) × $2,500 = $1,650]

To make this policy loan arrangement even more favorable for the employer, the policy loan interest may be tax deductible if the life insurance policy is on the life of a key person.

Warning: There is a risk when taking withdrawals down to basis and then changing to policy loans.  While this commonly-used strategy will continue to provide the funds tax free to the employer; there is, however, a need to use some caution.    If the policy is subsequently surrendered or permitted to lapse, the policyowner could experience "phantom income."  Phantom income (in this context) is taxable gain as a result of lapse or surrender — taxable gains without actual funds with which to pay the tax liability that arises upon termination of the contract.

Policy Surrender at Retirement

Some employers may not be concerned about recovering the costs of the deferred compensation plan. For these employers, maintaining the life insurance coverage beyond the employee's retirement date is less important. In such a case, the employer may select the cash value method of paying the benefits and may choose to surrender the policy and place the funds under an appropriate settlement option.

Depending on company practice, the employer may be permitted to elect to receive the maturity or cash surrender values under an income option for a fixed period of years. If the employer is obligated to pay an income to the employee for, say, ten years, then the employer may find it a convenient arrangement to elect a fixed-period income option for a 10-year period.

As the employer receives the periodic payments from the insurance company under the settlement option, these payments could in turn be paid to the employee to meet the terms of the deferred compensation agreement. The employee would incur income tax liability, of course, only to the extent of the amounts he or she actually received in the taxable year of receipt.

Although policy surrender and use of the cash value to pay the deferred compensation participant's retirement benefit is certainly an option available to the employer, the resulting loss of the policy's death benefit and the taxability of the employer-received cash value generally makes this choice unattractive.

Proceeds Paid at Death

At the employee's death, the employer collects the insurance proceeds income tax free. If the deferred compensation plan includes a survivor benefit, the employee's death also creates a liability for payment of the survivor benefit. The survivor benefit is generally paid from the employer's funds. Despite the tax-free nature of the death benefit proceeds the employer received, the payments made to the survivor are:

taxable income to the survivor; and
tax deductible to the employer making the payments.

The income the survivor received under the deferred compensation plan is considered income in respect of a decedent and is taxed as it would have been if paid to the employee.

Insurance Company Payment to Survivor

The plan participant may want the survivor payments to go directly from the insurance company to his or her spouse. In this case, the employer could arrange with many insurance companies to make payments directly to the surviving spouse — but subject to the corporation's right to rescind the payment order.

Even though the periodic survivor payments might be made directly to the survivor, the insurance company is acting as the agent for the employer in making the payments. The employer remains the sole payee, and the arrangement has no effect on the tax treatment of the payments.