The primary reason for the popularity of group term life insurance with employers is that it's viewed as a fairly inexpensive benefit. For the most part, it can be, especially if there are a number of younger, lower-paid workers on the payroll. However, when the business includes its older, higher-paid executives, including the owners themselves, the result can be a "so-so" benefit at an "oh-no" price.
The Group Carve-Out Alternative
As a business owner, you may want to consider what could be a more cost-effective alternative: group carve-out insurance. If you're providing across-the-board group term coverage for your employees, group carve-out can provide a valuable, win-win alternative; one that provides employees and the business with a bigger bang for the benefit bucks you spend. There's nothing wrong with traditional group term life insurance. Under most group policies, especially for small businesses, all employees are treated as part of a single group. Each individual receives a life insurance benefit equal to a multiple of his or her salary. Example: If the benefit is three times salary, a worker earning $24,000 a year will receive life insurance coverage equal to $72,000. As benefits go, it just doesn't get any simpler than that. (Amounts may be limited or governed by individual plan provisions.)
There's also a very nice tax break. The cost of providing up to $50,000 of death benefit is one hundred percent deductible to the employer.
Weaknesses of Group Term Life Insurance
Unfortunately, group term life insurance also has several serious weaknesses. This is especially true for businesses with older, higher-paid employees and owner-employees. Among the problems:
- Costs rise with age. Group term insurance can be quite cost-effective when predominantly younger workers are involved. However, costs increase every year. Premiums for employees in their 50s can be many times higher than the costs for workers in their 20s. By the time they enter their 60s, costs to continue providing this benefit can become prohibitive.
- Costs rise with income. Group term coverage works just fine when you
are talking about incomes for lower-paid employees. But take an
owner-employee or other key executive earning $175,000. At three times
earnings, he or she is now receiving $525,000 of life insurance benefit.
Couple age and income: since most highly-paid employees are also older, you could have massive costs for group term coverage at the top end. Plus, since rates are pooled for the group, the cost for including even a small number of older, higher-paid employees can drive up costs across the board.
- The tax break disappears for benefit amounts above $50,000. Up to that
point, the employee does not report the value of the benefit as income.
However, the value beyond that limit is treated as imputed income to the
employee, based on what is referred to as Table I costs provided by the
IRS. The result can be an unpleasant tax surprise.
Imputed Income Value
(Group Term Life Insurance)
Age Bracket Per $1,000 per month under 30 $.08 30 to 34 $.09 35 to 39 $.11 40 to 44 $.17 45 to 49 $.29 50 to 54 $.48 55 to 59 $.75 60 to 64 $1.17 65 to 69 $2.10 70 + $3.76
Take the example of a 60-year old employee with $500,000 of group term coverage. That means the employee must count the cost of $450,000 (everything above $50,000) as imputed income. Under current Table I rates, that value is calculated as $1.17 per $1,000 of benefit per month, which comes to $526.50 per month, or $6,318 a year.
Do the costs ever stop rising, or stop completely? Yes. But, unfortunately, so do the benefits. The life insurance benefit generally expires at retirement, or shortly thereafter, without value. In many instances, a great deal of money is spent to furnish a benefit that is never used. The irony is that group term insurance is a benefit that can be quite expensive before retirement and one that goes away after retirement.
The Mechanics of Group Carve-Out
The solution for a growing number of business owners is group carve-out insurance so named because older, higher-paid employees are 'carved out' of the group plan and are instead provided with permanent, cash value life insurance.
The mechanics of group carve-out are fairly simple. You reduce the amount of group term coverage on your highly-paid individuals to $50,000. The remainder of the benefit is put into permanent, cash value life insurance owned by the employee.
There are costs involved, but the more important question involves the value of the long-term benefit to the individual. There are several ways the costs can be arranged. For instance, let's say the corporation pays the employee the equivalent of what it would have paid for the comparable term coverage. Since the premium is treated as compensation, the amount is fully deductible to the corporation. While the employee pays taxes on the additional income, he or she acquires a growing asset in the form of a permanent life insurance policy.
There are a number of advantages to everyone under this arrangement. They include:
- The corporation can deduct 100% of its payments as a bona fide business expense.
- The benefit does not expire at retirement. Instead, since this is cash value life insurance, it accumulates cash value each year.
- The premium need not increase with age. Under many cash value policies, the premium can be locked in at the level when the policy was issued. Premium costs do not become prohibitively expensive in later years.
- It can dramatically improve the cost/benefit equation. Since higher-paid employees are carved out of the group term policy, the cost to the company for providing coverage for other employees is reduced.
- The employee owns the life insurance. Especially for owner-employees, this becomes a permanent, life-long benefit.
- It always pays, provided the coverage is maintained. Cash value life insurance provides lifelong insurance protection. With few exceptions, once the policy has been issued, it cannot be canceled by the carrier, provided all required premiums are paid. Regardless of health or other factors, the insurance remains in force.
- Higher initial premiums can actually be less expensive than term in the long run. Many of today's interest-sensitive policies pay dividends and have a premium offset plan feature. The premium offset plan allows premiums to be paid from non-guaranteed policy values. (A reduction in the applicable dividend scale may result in further out-of-pocket cash premium payments being made necessary.) As a result, premiums can be paid from policy dividends, yet coverage can continue for life. As a result, the long-term net cost can be quite low compared to the total costs for a term policy.
- It builds cash value. This amount can be used in the future for any purpose for a down payment on a home, to help pay for children's education or to supplement income in retirement. (Note: Borrowing cash value from your policy will decrease total policy values.)
Is a group carve-out arrangement right for you and your business? That will depend on a number of factors. But it certainly is worth finding out.
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