What is Split Dollar Life Insurance and How Does It Work?
One of the most common pain points we see in estate planning with life insurance is when the premium is larger than the gift tax exclusion, triggering a gift tax.
To avoid the gift tax liabilty, many clients use what is called a “split dollar” plan.
In this article, we've explained the inner workings of split dollar life insurance and provided a popular alternative known as third-party premium financing.
Here’s what we'll cover in this post:
Quick Article Guide
Here’s what we'll cover in this post:
360 Degrees of Financial Literacy explains split dollar life insurance as follows:
“Split dollar life insurance is an arrangement between an employer and an employee to share the costs and benefits of a life insurance policy. Specifically, the parties join together to purchase an insurance policy on the life of the employee and agree, in writing, to split the cost of the insurance premiums, as well as the policy's death proceeds, cash value, and other benefits. The actual life insurance policy used can be whole life, universal life, second-to-die (survivorship), or any other cash value policy.”
“Most split dollar plans are used in business settings between an employer and employee (or corporation and shareholder). However, plans can also be set up between individuals (sometimes called private split dollar) or by means of an Irrevocable Life Insurance Trust (ILIT).”
In a private split dollar plan, money is gifted to the ILIT to pay the life insurance premiums. I will explain in a little more detail shortly.
When someone owns a large estate, they will usually seek an ILIT to “hold” their life insurance. FindLaw explains:
“Like most trusts, [an ILIT] is simply a holding device. It owns your life insurance policy for you; removing it from your estate to avoid the estate tax liability. As its name suggests, the Irrevocable Life Insurance Trust is irrevocable. That means once you've created it and placed an insurance policy inside it, you can't take the policy back in your own name.”
The article continues:
“But you can closely control many other aspects of the ILIT. You can dictate who your initial beneficiaries will be and define the terms under which they will receive benefits. You can choose the Trustee (or Trustees) who will manage your ILIT.
An ILIT provides you, your loved ones, and your estate with considerable advantages. But these benefits can only be achieved if the ILIT is designed properly and specific guidelines are followed carefully.”
The problem arises when the premium of the insurance policy is larger than the amount the policyholder can exclude annually through gifting. The exclusion is currently set at $14k per recipient, which both spouses can gift separately for a total of $28k per recipient. So, if there are, for example, two beneficiaries to the ILIT, a total of $56k can be gifted per year.
Now, what if the premium is $100k? That would trigger a gift tax for the remaining $44k to the premium. There is the option to cut into the lifetime exclusion, which was $12.06 million as of 2022. However, most people would prefer not to eat away at their lifetime exclusion.
With a split dollar plan in place, the trust owes back either the cumulative premiums paid or the cash value of the life insurance—whichever is greater—upon the policyholders’ deaths. Investopedia explains:
“Private split-dollar arrangements are usually between family members or trusts they have established, rather than the more common split-dollar plans between an employer and employee. Although plans could be set up between non-related individuals. Part of the appeal is the opportunity to leverage annual gifts and generation-skipping transfers. The proceeds are used to purchase a life insurance policy. To keep the death benefit out of the insured's estate, the policy is usually owned in an ILIT. This arrangement helps provide liquidity for the estate upon the insured's death and can also help reduce federal and/or state estate taxes obligations”
A similar solution to a split dollar plan is third-party financing, which is exactly what it sounds like. You borrow money from a third party, such as a bank, to pay your life insurance.
Many people consider third-party financing because they don’t have to use any of their exclusion at all, and the entire premium is borrowed. You can gift the interest of the loan—which will likely be relatively low—each year so that the trust can pay the interest on the debt.
The loan eventually has to be repaid, which you may choose to accomplish via the death benefit in the life insurance policy. Whatever is owed to the bank when you die is taken out of the payout, and your family receives the remaining funds. The policy is essentially collateral for the loan. However, be aware that premium financing does have some risks, namely interest rate volatility, policy renewal, and poor policy performance.
“Because most premium financing contracts have terms less than the life of the policy, they have to be renewed periodically, requiring refinancing.”
Investopedia makes a very important point about policy performance in cash value life insurance, writing:
“If the policy’s cash surrender value underperforms, the loan balance could exceed the value of the collateral, in which case the insured would be forced to provide more collateral to avoid default. Likewise, if the death benefit fails to grow, the policy could provide less coverage than expected when the loan is finally satisfied. In the worst cases, the insured’s estate would have to repay the loan if the death benefit could not.”
Split dollar plans and premium financing also have their drawbacks. With premium financing, the amount of your loan grows each year as you continue to borrow insurance premiums.
With split dollar plans, each year you age, the imputed cost of your life insurance rises. If you live long enough, the costs can easily exceed the death benefit of your policy. Therefore, it’s important to have a way for the Trust to repay the balance of your premium financing loan or split dollar arrangement.
The most common ways to accomplish this are by creating a GRAT, IDIT, or a Charitable Lead Trust. With all three strategies, the Trust obtains a highly-appreciating asset without incurring a gift tax. This asset is later used to repay any money owed to the insureds' premium financing loan or split dollar arrangement.
We've further explained each trust below:
A Grantor Retained Annuity Trust (GRAT) allows you to put money into the trust and receive an annual income. It functions just like an annuity, and allows you to place an asset without using the gift tax exclusion.
The idea is to have the value of the income stream that you’re getting back equal the amount that you’re putting into the trust so that there is no gift at all. The annuity is for a fixed period, after which the asset is received by the trust, and there are no more annuity payments to the individual, assuming they are still alive.
If the individual does not survive the annuity term, a portion of the value goes back into the estate. Attorneys often turn to two-year GRATS as a means of avoiding the ups and downs that can happen over a longer term.
An Intentionally Defective Irrevocable Trust (IDIT) functions similarly to a GRAT in that the trust receives an asset that will hopefully grow and be used to pay off the life insurance loan. But instead of an annuity, an IDIT actually sells the asset to the trust and the trust distributes yearly payments. Since the trust owns the asset, there are no capital gains taxes. ThinkAdvisor explains the many other benefits of an IDIT.
Charitable Lead Trust
A charitable lead trust is somewhat self-explanatory in that it pays a charity for a set period of time. Investopedia gives more detail:
“The whole idea of a charitable lead trust is to reduce taxes upon the estate left by the deceased. This is done by donating to charities from the estate until all taxes are reduced. Once this is accomplished, the estate is then transferred to the beneficiaries, who typically will face lower taxes.
Many different organizations offer information regarding the set-up of these types of trusts. Examples are universities, colleges, and non-profit societies.”
Because split dollar plans are somewhat complex, it’s best to work with an attorney and an experienced insurance agent—preferably one who is independent and not “captive” to a single company.
JRC Insurance Group is an independent agency specializing in life insurance and estate planning strategies. We take great pride in helping families protect their financial future, and would be happy to assist you with your life insurance needs.
There is no charge for our services, nor are there any obligations. Learn more here, or call us today toll-free at 855-247-9555, or request a free instant quote online to compare rates from dozens of top-rated insurance companies in less than a minute.
Managing Partner and Co-founder
Cliff is a licensed life insurance agent and one of the owners of JRC Insurance Group. He has helped thousands of families of businesses with their life insurance needs since 2012 and specializes with applicants who are less than perfect health. In his spare time he enjoys spending time with family, traveling, and the great outdoors.