Using Life Insurance to Finance a Death Benefit Only Plan

Most DBO plans promise to make payments over a number of years (e.g., $100,000 per year for ten years, if death occurs prior to age sixty-five). Assume a plan promised a $10,000 annual death benefit for ten years to the surviving spouse of a key executive, otherwise to the executive’s children. Assume the employer corporation is expected to be in a 40 percent (or higher) combined state and federal income tax bracket at the time payments are made. After its $4,000 deduction for each payment, the net cost would be only $6,000 per payment. So it could purchase a $60,000 policy on the employee’s life, and even if it earned no interest on the unpaid balance, it would have sufficient funds to make the promised annual payments. Actually, when interest earnings are factored in, the policy death benefit could even be less than $60,000.

The corporation would own and be the beneficiary of the policy and pay all premiums. Note that the $60,000 of life insurance would be received by the employer-corporation income tax free (and, in this example, because of the relatively low amount of insurance, would probably not be subject to any AMT). However, in the case of a larger life insurance policy, planners should multiply the target amount that the employer firm needs to net by 118 percent, in order to find the proper level of insurance to purchase (assuming a worst case scenario and a large corporation). For example, if the company needed to net $60,000 in a worst case situation, it should purchase $70,800 ($60,000 × 1.18) worth of insurance coverage.

If the benefit is to be paid to the beneficiary over a period of years, rather than in a lump sum, the amount of life insurance needed by the corporation is further reduced. This is because the corporation can invest the life insurance proceeds received at the date of the employee’s death. Since it will pay those funds over a number of years, it can continue to invest any balance and use the net after-tax interest income to help fund the benefit payments. The use of a calculator or software package with discounting tables will quickly show the low cost of providing a large benefit when the employer can use both tax leveraging and the time value of money. Alternatively, the employer could obtain the full amount of insurance needed and use interest earnings as a cost recovery vehicle to reimburse itself for premium outlays. For instance, in the example above, by purchasing $100,000 of coverage, rather than $60,000 or $70,800, the corporation would have much more than necessary to make the promised payments. The excess could serve as an economic shock absorber and a way to return to the corporation a significant portion of its premium outlays.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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