ADVANTAGES OF GROUP CARVE-OUTS


Employer Advantages

There are five principal advantages that inure to the employer that installs a group carve-out plan:

reduction in group term life insurance discrimination concerns;
no cost increase;
ability to limit participation;
current employer tax deduction; and
encouragement of executives' active participation.



Reduction in Group Term Discrimination Concerns

For group insurance to meet the definition of group term life insurance and qualify for special tax exclusion by employees, it must meet conditions relating to the:

nature of the death benefit;
group for whom it is provided;
employer's participation; and
nondiscriminatory method of determining insurance amounts.

If a group term life insurance plan fails to meet these conditions, participants will be unable to exclude the value of the first $50,000 of term life insurance from their current income. This is an important condition for employers, because the senior executive group may have life insurance needs that are substantially greater than those of other employees.

The group carve-out plan removes the nondiscrimination concern by eliminating group term life insurance coverage in excess of $50,000 for the executives chosen to participate.


No Cost Increase

It is likely that there would be no increase in employer cost to provide an identical amount of life insurance coverage as a combination of group term insurance and universal life insurance, unless the total death benefits are increased or the employer chooses to make supplemental contributions. Normally, the universal life insurance policy's minimum premium is comparable to the cost for the same amount of group life insurance.

In fact, the use of a group carve-out plan may actually decrease the employer's overall costs to provide life insurance to its employees. In the typical employee census, the senior executives normally have the highest level of group term life insurance and also tend to be the oldest employees in the group. By removing these older executives from the group insurance census for group term life insurance amounts in excess of $50,000, the average age per $1,000 of group term life insurance may decrease. This decrease could favorably affect group term life insurance rates overall for the group.


Ability to Limit Participation

Unlike group term life insurance, the separation of coverages into a base amount of $50,000 of group term life insurance and a universal life insurance policy for the remainder permits the employer-if it chooses-to provide significantly increased life insurance benefits to selected executives. Because the group term life insurance coverage provides a base coverage amount of $50,000 on all executives, there is no employer concern about the group plan being discriminatory.


 Current Employer Tax Deduction

The employer receives a current income tax deduction for the entire premium paid for both the group term life insurance and the employee-owned universal life insurance policy. The group term life insurance premium is deductible as an employee benefit, and the employer-paid portion of the universal life insurance policy premium is deductible to the employer as compensation. Accordingly, the premium for the universal life insurance policy is included in the executive's income for tax purposes-just as the Table I costs would be if the entire life insurance coverage were provided under the group policy.



Executives Encouraged to Participate

Because the universal life insurance policy generally provides both a competitive and tax-deferred rate of return coupled with FIFO tax treatment of withdrawals, the executives often make additional premium contributions to the universal life insurance policy. The policy represents an attractive and tax-wise investment alternative.



Split-Dollar Approach to Cost Recovery

An employer may seek to recover its premium payments for the universal life insurance policy issued under the group carve-out plan. An employer looking for premium cost recovery can accomplish that by employing a split-dollar approach to the universal life insurance policy.

This approach splits the death benefits between the employer and the executive's personal beneficiary. If the executive dies during the plan, the employer's portion of the death benefit is equal to the greater of the cumulative premiums it has paid or the policy's cash value. The amount of the death benefit that exceeds the employer's share is payable to the executive's beneficiary.

Under this approach, the employer also owns its portion of the cash value. This fund is available for business needs and emergencies. If the executive lives to retirement, the employer can use the cash value of the policy to fund a special retirement plan for the employee if it chooses.


Split Dollar Approach to Cost Recovery

An employer may seek to recover its premium payments for the universal life insurance policy issued under the group carve-out plan. An employer looking for premium cost recovery can accomplish that by employing a split-dollar approach to the universal life insurance policy.

This approach splits the death benefits between the employer and the executive's personal beneficiary. If the executive dies during the plan, the employer's portion of the death benefit is equal to the greater of the cumulative premiums it has paid or the policy's cash value. The amount of the death benefit that exceeds the employer's share is payable to the executive's beneficiary.

Under this approach, the employer also owns its portion of the cash value. This fund is available for business needs and emergencies. If the executive lives to retirement, the employer can use the cash value of the policy to fund a special retirement plan for the employee if it chooses.



 Advantages for the Executive

The advantages to the employer, however substantial, are not as significant as the advantages that inure to the executive under a group carve-out plan. They include:

an opportunity to maintain death benefits beyond retirement;
the tax-deferred accumulation of voluntary contributions;
portability; and
the ability to use cash values to supplement retirement income.


Death Benefits Beyond Executive's Retirement

A serious drawback to group term life insurance is its termination upon retirement. In most cases, if the executive elects to continue the coverage it must be converted to permanent life insurance at the executive's then-current age. Because life insurance premiums are age-based, the executive's premium for the converted coverage may be substantial just at a time when his or her income is reduced.

Under a group carve-out plan, the portion of the insurance provided by universal life may continue beyond the executive's retirement. Although the executive may be required to pay ongoing premiums, those premiums generally are much lower because they are based on the executive's age at the time the group carve-out plan began-possibly many years before the executive's retirement.


Tax-Deferred Accumulation of Voluntary Deposits

Because the employer pays the group carve-out premium for the universal life insurance policy equal to the policy's minimum premium, policy costs that are levied on a per-policy or per-thousand dollar basis are paid by the employer. For that reason, the executive's voluntary deposits in excess of the minimum premium produce generally greater returns than the policy's interest crediting rate would appear to offer.

 For example:

 A particular universal life insurance policy providing a $500,000 death benefit to a 45-year-old insured for a $2,580 minimum premium has a cash value at age 65 of $7,500 at a crediting interest rate of 6.75 percent. If the executive makes additional voluntary premium deposits of $6,000 each year for the 20-year period, the cash value at age 65 would increase to $282,000, an increase of $274,500. In other words, the $6,000 voluntary contribution made each year accumulates to almost $275,000, an approximately 7.3 percent annual return, rather than the 6.75 percent interest crediting rate.

When we consider that the growth in the policy's cash value is entirely tax-deferred until it is withdrawn, the 7.3 percent return may be much higher considering the executive's marginal income tax bracket. Finally, the FIFO tax treatment afforded any withdrawals from the policy (provided it is not an MEC) makes the executive's voluntary premium deposits a wise and tax-efficient investment strategy.


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.


Portability

Unlike group term life insurance, the universal life insurance policy purchased pursuant to the group carve-out plan continues in force even if the executive's service with the employer does not. If the executive leaves the employer's service for any reason, the executive takes the policy.


Supplement Retirement Income

The universal life insurance policy purchased under the group carve-out plan may be used to provide supplemental income for the executive at retirement. The supplemental income, because of the FIFO nature of life insurance policy withdrawals and the ability to change to policy loans once basis is reached, may be received by the now-retired executive entirely free of income taxes.

Continuing the earlier example:
The executive made voluntary premium contributions of $6,000 yearly for 20 years. The executive could arrange to receive, through a combination of cash value withdrawals and policy loans, an income of $25,500 each year for the 10 years following retirement. The executive received that income without any income tax liability though the funds received are substantially greater than the executive's cost basis. Furthermore, the life insurance policy can be expected to remain in force until the executive's age 100 and, at age 85, will still pay a death benefit of $100,000. Clearly, the group carve-out plan has provided important benefits to the executive participant.