PRINT -- Chapter 5
Group Carve-Out Plan
The important points addressed in this lesson are:

A key executive covered under a group carve-out plan can overcome the group term life insurance limitations resulting from the group term insurance non-discrimination requirement

The universal life insurance policy issued in a group carve-out plan is portable and may be continued by the executive beyond retirement

A participant in a group carve-out plan avoids the Table I imputed income costs for group term life insurance coverage in excess of $50,000

The universal life insurance policy issued under the group carve-out plan has tax-deferred cash values that may be accessed by the executive to provide additional retirement income




A Group Carve-Out Primer

An important first step in understanding group carve-out plans and their advantages is an appreciation of group term life insurance and its requirements. For that reason, we will begin this Chapter by considering group term life insurance.


Limitations of Group Term Life Insurance

There is little disagreement that, over the six plus decades that group term life insurance has been generally available, it has become a major force in the life insurance business; clearly, it occupies an important place in many individuals' plans.  However, group term life insurance has certain requirements and limitations that adversely affect its ability to meet many executives' long-term life insurance requirements.  These limitations include its:

Non-discrimination requirement
Reduction or termination at retirement
Loss upon termination, and
Imputed income costs for coverage over $50,000


Non-Discrimination Requirement

Group term life insurance coverage must be provided on an even-handed, non-discriminatory basis.  If a plan of group term life insurance is deemed discriminatory, its tax advantages may be lost.  


Coverage Adversely Affected at Retirement

One of the concerns about group term life insurance is that it is normally reduced substantially or eliminated when the participant retires.  In the event that coverage is continued after the participant retires, its cost may become substantial.  An alternative, of course, is the conversion of coverage at retirement, but this also adds substantial cost at a time when the retirees' income has declined.


Coverage Lost Upon Termination

Group term life insurance coverage cannot be taken with a departing employee.  On termination of service, the group insurance ends.  


Table I Rates over $50,000

Large amounts of life insurance delivered as group insurance has certain tax inefficiencies.  Employees must report the value of group term life insurance coverage in excess of $50,000 as imputed taxable income.  The amount of taxable income resulting from group coverage over $50,000 is based on government Table I rates that may be higher than the actual cost for the group insurance.

Group carve out plans are designed to overcome each of these normal group term life insurance limitations.


Operation of the Group Carve-Out Plan

Group carve out plans simply replace existing group term life insurance amounts over $50,000 on the life of selected executives with individual universal life insurance coverage.  Declared rate, equity-indexed or variable universal life may be used, depending upon the individual executive's wishes and risk tolerance level.

The employer's premium payments generally remain constant.  It continues to make premium payments for the now-reduced group term life insurance coverage but also makes premium payments for the universal life insurance policy at least at the minimum premium level.  In many cases, the universal life insurance policy's minimum premium is fairly close to the premium for the replaced group term life insurance.

If minimum universal life insurance premiums are made by the employer, the combination of group term life and group carve out plan functions in a manner very similar to the group term insurance plan before the carve out.  A major difference, however, is that both the employer and the executive may make additional premium payments to the universal life insurance policy.  As a result of additional premiums:

Cash values may be increased
Post-retirement life insurance protection can be provided, and
Supplemental retirement income can be created

In addition to these benefits following on the heels of additional premiums, the simple fact of the carve-out adds an element of portability.  Although the group term life insurance would, of course, end if the executive terminated, the universal life insurance portion remains in force and moves with the executive.  


Group Carve-Out Plan Description

There are several benefits that follow the creation of a group carve-out plan, such as selectivity, portability, avoidance of imputed income and the ability to keep life insurance coverage beyond retirement.  Let's consider each of these benefits in somewhat greater depth.


Selective Coverage

One of the important characteristics of nonqualified plans is the employer's ability to decide who will be covered by them and who won't be.  Whether we consider it selectivity or discrimination is immaterial: it is a significant departure from qualified plans.  In the case of group carve-out plans, a class of executives is usually selected to participate.  For example, the class may be -- and often is -- comprised of "all vice presidents."  As is the case in other plans, this selectivity permits the employer to provide greater recognition to selected key executives.


Coverage Beyond Retirement

Life insurance needs don't generally change significantly when an individual retires.  In large measure, all of the things that needed to be done in the event of death before retirement need to be done after retirement.  Surviving family members need to continue to receive income, mortgages need to be paid, and so forth.  By personally owning the universal life insurance policy that replaced the group term coverage, the executive can continue it beyond retirement.  If he or she has added extra premiums while employed, that coverage may continue into retirement without the need to make additional premium payments.


Coverage is Portable

Since the executive owns the universal life insurance policy, its coverage is portable.  In other words, the universal life insurance policy continues despite the executive's termination of his or her service with the employer.


Table I Costs Eliminated

The imputed income that arises because of the group term life insurance coverage that exceeds $50,000 is calculated using rates in government Table I.  Accordingly, the imputed income is known as the Table I cost.  Table I costs are eliminated in a group carve out plan.  The Table I rates are as shown in the chart below:


Table I Uniform Premiums for $1,000 of Group Term Life Insurance Protection
 5-Year Age Bracket
 Monthly Cost Per $1,000 of Protection

Under 25

$.05
25 - 29
.06
30 - 34
.08
35 - 39
.09
40 - 44
.10
45 - 49
.15
50 - 54
.23
55 - 59
.43
60 - 64
.66
65 - 69
1.27
70 and above
2.06


Group Carve-Out Advantages

As we have already noted, group carve out plans offer advantages to the executives that are included.  They also offer employer advantages.  


Employer Advantages

The principal employer advantages of a group carve-out plan include:

Discrimination concerns are reduced
Benefits are conferred without an increase in cost
Participation in the plan may be limited by the employer, and
Employer continues to receive a current tax deduction


Reduction in Group Term Discrimination Concerns

To qualify for group term life insurance's employee tax exclusion, group term life insurance must meet four conditions relating to the:

Nature of the death benefit
Group for whom it is provided
Employer's participation, and  
Method of determining insurance amounts

If a group term life insurance plan fails to meet these conditions, the participants' ability to exclude the value of the first $50,000 of term life insurance from current income will be lost.  One of the conditions that may cause employer concern is the requirement that life insurance amounts not be discriminatory.  Since senior executives may have larger life insurance needs than other employees -- if only to continue larger incomes for family survivors -- the general inability to provide them with larger group life insurance benefits is confining.

By eliminating group term life insurance coverage in excess of $50,000 for the executives chosen to participate, the group carve-out plan causes much of the discrimination issue to disappear.  


No Cost Increase

Typically, there is no cost increase to provide the same amount of life insurance coverage as under the group plan through a combination of group term life insurance and universal life insurance.  Of course, if the death benefits are increased or supplemental voluntary contributions are made, those changes would change the premiums.  As we noted earlier, the minimum premium for the universal life insurance coverage is about the same as the cost for an identical amount of group life insurance.

In practice, a group carve-out plan may reduce the employer's overall employee benefit costs.  Senior executives -- the ones usually included in group carve-out cases -- usually have the highest level of group term life insurance and are also the oldest covered employees.  Because of that, an employer will typically reduce its overall group term life insurance rates by removing them for group term life insurance amounts in excess of $50,000.   


Ability to Limit Participation

Although group term life insurance must not discriminate, such is not the case with respect to the carve-out amounts.  As a result, the employer may provide much larger total life insurance benefits to chosen executives.  There is no concern about any group plan discrimination since the group term life insurance coverage provides a base coverage amount of $50,000 on all executives.


Current Employer Tax Deduction

The premiums that the employer pays for the group term life insurance and the employee-owned universal life insurance policy are tax-deductible, although not for the same reason.  The premium for group term life insurance can be deducted as an employee benefit; the premium for the universal life insurance premium is deductible as compensation.  Since the universal life insurance premium is compensation to the insured executive, it is included in his or her taxable income.  However, even if the group carve-out plan were not implemented, the executive would have taxable income anyway because of the Table I costs.




Group Carve-Out Executive Advantages

The advantages to the executive far outweigh the employer advantages and include:

Post-retirement death benefits
Tax-deferral of earnings on voluntary contributions
Portability, and
Supplemental retirement income


Post-Retirement Death Benefits

One of the disadvantages of group term life insurance is that it normally terminates when the executive retires.  If the executive converts the lost group term insurance to permanent life insurance, the premium will be based on the executive's age at his or her retirement.  Because of the age-based nature of life insurance premiums, the cost for the coverage may be prohibitively expensive.  Coupled with the executive's normal reduction in income upon retirement, it could mean that the needed life insurance may not be affordable.

The universal life insurance portion of the coverage provided in a group carve-out plan is not affected by the executive's retirement (except to the extent that the employer no longer pays the minimum premium towards it) and may continue beyond the executive's retirement.  Even though the executive may need to pay subsequent premiums, they may be much smaller than the premiums required upon conversion.  


Tax-Deferred Accumulation of Voluntary Deposits

In a group carve-our plan, the employer's universal life premium pays the bulk of the policy costs. As a result, additional premium payments grow at a generally faster rate than minimum premiums.  So, the executive's additional premiums result in typically greater returns than the policy's interest crediting rate would appear to offer.  Those greater returns coupled with both tax-deferral and FIFO tax treatment of withdrawals result in significant benefits.


Portability

Executive movement in many industries is a fact of life, and the ability to take benefits with the executive upon termination generally has some appeal to executives.  Although group term life insurance terminates when the executives leaves the employer's service, the "carved-out" universal life insurance policy continues in force.  So, whether the executives resigns or retires, the coverage goes with him or her.


Supplement Retirement Income

We have previously discussed the use of universal life insurance withdrawals and policy loans to effect a tax-free income at retirement. The universal life insurance policy in the group carve-out plan may be used in precisely the same manner to create a supplemental retirement income.  This income may be received entirely free of income taxes due to the FIFO nature of life insurance policy withdrawals and the ability to change to policy loans when the policyowner's cost basis is reached.  




Plan Tax Considerations

The attractiveness of group carve-out plans is generally enhanced by its tax treatment, which involves:

Premium deductibility
Executive recognition of employer universal life premiums, and
Tax-deferral of universal life cash values


Employer Premiums Deductible

Premiums paid by the employer in a group carve-out plan include both the group term life insurance premium and the universal life insurance policy premium.  Both are income tax deductible to the employer: the first as an employee benefit, and the second as executive compensation.  


Executive Taxed on Universal Life Premium

Since the employer receives an income tax deduction as compensation for its universal life insurance policy premium payments, that amount is taxable to the executive.  Despite that executive taxability, however, the executive's bonused income resulting from the premium payment may be less than the imputed income under Table I.  (Remember, the Table I cost would apply if the coverage had been provided as group term life insurance.)  


Employee Cash Values Tax-Deferred

The universal life insurance policy's taxation is the same as that afforded any personally purchased life insurance policy.  Specifically, the growth on cash value is tax-deferred, and policy withdrawals are subject to FIFO tax treatment.

For an employee in a high tax bracket, the combination of these tax benefits may make a substantial difference in the amount of after-tax income received.  Consider the accumulation benefits of simple tax-deferral shown in the table below.  If an investor in a 33 percent tax bracket placed $5,000 each year into a tax-deferred account and $5,000 in a currently-taxable account simultaneously, the results would be substantial as the years wore on.

By the end of 10 years, the investor would have $9,024 more in the tax-deferred account.  Only five years later, the difference would have grown an additional $15,000 and would stand at $24,087.  It is not until 20 years and later that we see the very large differences: $51,806 after 20 years, $175,548 after 30 years, and almost a half-million dollars difference after 40 years.  

It could certainly be argued, however, that the funds in the tax-deferred account would need to be exposed to taxation before the investor could use them.  While conceding that point, the difference may still be substantial.  If the investor withdrew all of his or her funds from the tax-deferred account at the end of 20 years -- not normally the most tax-wise approach -- he or she would still be more than $12,000 ahead in the tax-deferred investment.

When we factor into the equation that the executive can access the tax-deferred universal life insurance cash values on a tax-free basis through withdrawals to basis followed by policy loans, the difference in results is even greater.


Benefits of Tax Deferral --  $5,000 Annually; 33% Tax Bracket
 End Of Year
 Tax-Deferred Accumulation at 7%
 Currently Taxable Accumulation at 7%
    Difference
1
 $       5,350
 $     5,235
$ 115
2
11,075
10,714
361
3
17,200
16,452
748
4
23,754
22,458
1,296
5
30,766
28,745
2,021
10
73,918
64,894
9,024
15
134,440
110,353
24,087
20
219,326
167,520
51,806
30
505,365
329,817
175,548
40
1,068,048
586,478
481,569


Summary

Group carve-out plans enable an employer to overcome the substantial group term life insurance limitations that result from the various requirements that it must meet.  For the employer, the benefits of a group carve out plan include an avoidance of discrimination concerns, the providing of additional benefits without an increase in cost, the ability to choose which executives may participate and a current income tax deduction. By using a group carve-out plan, the executive's coverage provides post-retirement death benefits, tax-deferral of earnings on voluntary contributions, portability and supplemental retirement income.  

These plans provide substantial advantages to both employers and executives without any significant disadvantages.