Employer-paid group insurance generally works well in providing basic coverage for all employees. However, it may have unintended consequences that may not be understood or worse, overlooked.
In addition, most employees with large group life insurance death benefits don't fully understand the financial impact Table 1 costs will have on them, personally (Table 1 is the government's method for calculating the taxable premium of employer-provided life insurance and is commonly known as imputed income.).
For example, an employer provides $950,000 of group insurance for their vice presidents. Section 79 of the Internal Revenue code allows the first $50,000 of employer-paid group term insurance to be excluded from the gross income of the employee. So, in this case the employee would owe imputed income taxes on $900,000 of benefit ($950,000 - $50,000 = $900,000).
Even though employees do not receive cash, they are taxed as though they had received cash in the amount equal to the taxable value of their coverage. Using Table 1 government rates and assuming a vice president is age 55, the value of this $900,000 of employer paid coverage will be the tax on an additional $4,644 of income. Assuming a 40 percent tax rate, that is an additional $1,857.60 in tax liability. The tax bite only gets worse as an employee ages.
All too often when a company provides a life insurance program for its employees, little thought goes into answering the question, "What is it that we're trying to accomplish for our employees with our life insurance program?" Another instance of "ready, shoot, aim."
Most firms will take the easy way out when executives seek more insurance. The response is quite predictable: "We will increase the amount of our group insurance. Why not? It's inexpensive."
While group life insurance is a low cost benefit for a company, it could have disastrous tax consequences for the people it covers, particularly older employees. For example, the firm increases the coverage and adds a supplemental program on a pre-tax basis and assumes that the problem is solved. They believe this to be a worthy solution because their consultant said it was the most cost-effective course of action.
This might be a good solution for the firm, but not necessarily for its executives. Without recognizing it, the company might have increased the older executives' tax burden by as much as $2,000 a year and with pending tax increases, this situation may only get uglier.
Since older executives often have an eye toward retirement, there's a common assumption that higher compensated executives engage the services of highly competent financial planners and have supplemental life insurance strategies in place. The fact is, in most instances, they don't. Typically, they're spending their time making money for the company and haven't taken care of their personal needs for retirement.
In many instances, they are looking for their employer to, as the saying goes, "take care of them." Some executives assume they can convert or carry over a portion of their group plan. More often than not, this is not the case, or it's just not practical to do so. So the group product they may come to rely on and have paid high taxes on every year, typically will not be part of this planning after they leave the firm, since it's not portable.
The story doesn't need to end with the retiring executives waking up to the realization that their group life coverage his disappeared. There are options that can be considered. For instance, there are life insurance programs for executives that cover them while they're working and become portable at current rates when they retire. Most of these products have the same desirable characteristics: they are cost-effective, portable and they can become part of an executive's estate plan. These plans usually save the executive from unnecessary higher income taxes while they are working.
Typically, these other products fall into three main categories:
No. 1: a group universal life product
Group universal life insurance is a permanent product with a cost of insurance component (term costs) that's usually paid for by the employer and included as income to the executive. Many times this cost may be lower than the cost of group insurance coverage. Usually, it will reduce the executive's current income tax liability significantly.
The product also features a cash value component, which allows the executive to add funds through payroll deduction. Generally, these funds grow on a tax-deferred basis. This product is fully portable at current rates when an executive separates from service.
No. 2: individual universal life
A slightly less popular option is an individual universal life insurance product that's written on a guaranteed issue basis. It comes with all the benefits of the group universal life product, while the cost of insurance (term cost) might be significantly less when an employee becomes older.
No. 3: convertible term
This product offers another approach. It can be written on a guaranteed issue or guaranteed acceptance basis. Guaranteed acceptance means the executive will be subject to medical underwriting; however, no one can be turned down for coverage. In most cases, this is the less expensive option for the firm and the most flexible for the covered executive. The product can be fully or partially converted later to a permanent product with no further medical underwriting.
All three of these programs should be considered when increasing coverage on a select group of employees and executives. Tax savings, portability, conversion options and perhaps cost savings, will go a long way in attracting, satisfying and retaining key talent.
