The Insurance Based Retirement Plan

Funding It for the Business Owner

One of the biggest challenges for a successful business owner is determining the most tax-efficient way to save for retirement. Contributions to qualified plans are tax deductible, but those plans have contribution limits, may require owners to contribute for more people than they want, and have significant and expensive administration and regulatory requirements.

Because of its flexibility, the nonqualified deferred compensation plan seems attractive at first. Unfortunately, it loses much of its appeal when the owner discovers that there is no current income tax deduction for contributions to the plan.

Personally owned variable universal life insurance is an attractive vehicle for cash accumulation, particularly because of the ability to invest in equity-based sub-accounts. The underlying investment options to a variable life insurance product are not publicly traded mutual funds and are not available directly for purchase by the general public. They are only available through variable annuity/variable life insurance policies issued by life insurance companies.

In addition to the ability to be invested in equity-based sub-accounts, variable universal life insurance provides potential tax-deferred growth in the policy and can provide tax-preferred access to internal values. This access allows the policy owner to use the policy in retirement to supplement retirement income. Access is accomplished through a series of partial surrenders to recover basis, switching to loans when the policy’s cost basis is recovered. Doing so allows the policy owner to generate cash flow without creating taxable income. The concept is generally referred to as the Insurance Based Retirement Plan. It offers a valuable way to supplement retirement income.

Asofsp’s Overloan Protection Rider and Automated Income Monitor can make the Insurance Based Retirement Plan technique even more attractive.

The Insurance Based Retirement Plan concept assumes the contract qualifies as life insurance under Internal Revenue Code (IRC) Section 7702, and that the contract is not a modified endowment contract (MEC), as defined in IRC Section 7702A. As long as the contract meets non-MEC definitions under Section 7702A, most distributions are taxed on a first-in/first-out basis.

Loans or partial withdrawals will reduce the death benefit payable to beneficiaries. Surrender charges may apply to partial withdrawals. Loans and partial withdrawals from a MEC will generally be taxable on a last-in/first-out basis and will be subject to a 10% tax penalty if taken prior to age 59 ½. Additionally, loans and withdrawals coupled with market performance can result in the need to add additional premium to prevent lapse. In the event of a lapse, loans in excess of basis will be subject to taxation as ordinary income in the year of lapse.

The Question: How to Get Money Out of the Business for the Policy?

The answer to that question has a lot to do with the form of business organization. Tax-efficient ways of getting money out of pass-through entities differ markedly from those for getting money out of C Corporations. The simplest approaches are often the best.

Ways to Get Money Out:

Owners of Pass-Through Entities
1. S Corporation owners: S corporation distributions
2. Partnerships & LLCs: Capital distributions
3. C Corporation Owners
  - Additional compensation
  - Dividends

We’ll also have a look at Collateral Assignment Split Dollar (CASD), which at one time was considered a very tax-efficient approach for the C Corporation owner to get money out of the corporation.

Owners of Pass-Through Entities

S Corporations

Because the corporation is respected by the law as being an entity separate from its owner, the owner of an S Corporation can be an employee of the corporation. Therefore, many people think giving the owner a raise in pay (i.e., additional compensation) is a viable approach to getting money out of the corporation.

This raise in pay technique is called Executive Bonus or a Section 162 Plan. “Section 162” refers to the Internal Revenue Code (IRC) Section 162, which allows a business expense deduction for the “ordinary and necessary” expenses of a business, specifically including “reasonable compensation.” §162(a)(1) IRC.

Actually, a raise in pay doesn’t make much sense, especially for the 100% owner of an S Corporation. See Table One for a simple hypothetical example of the effect a $50,000 year-end bonus has on the owner’s individual taxable income.

(This example and those that follow are not meant to represent a specific client or client situation.)

As you can see, even though we gave the owner a $50,000 bonus, it didn’t change the taxable income on his individual income tax return.

Actually, for the sake of the example, we ignored one thing—payroll taxes. The 2.9% Medicare Tax is levied on all wages, without limit. Therefore, if we did give the owner a $50,000 bonus, we would actually reduce the overall income by $1,450 (2.9% of $50,000). So, if we did give the owner a raise, it would cost them at least additional Medicare Tax.

Here, we looked at someone whose pay is no longer subject to Social Security Tax—the tax for Social Security retirement benefits. If the wages had still been subject to that tax, then the overall income could have been reduced by as much as $6,200, to cover that tax:
12.4% (employer’s and employee’s halves) × $50,000 = $6,200

Solution for the S Corporation Owner: S Corporation Distribution

So, what is the solution for the S Corporation owner? The solution is an S Corporation distribution.

What is an S Corporation Distribution?

Technically, it’s a dividend, but it is not like the dividend one receives from a publicly traded company. S Corporation profits are taxed at only one level—the shareholder level.

S Corporation shareholders are taxed when the profit is earned, which isn’t necessarily when the cash is available to distribute the profits.
Therefore, when they eventually take the profit out of the corporation, the distribution will generally not be taxable.
Typically, S Corp shareholders use S Corp distributions to pay the income tax on their shares of the S Corp profits.

Limitations on S Corporation Distributions (With Multiple Shareholders)

There are practical limitations on S Corporation distributions if there are two or more shareholders.

For example:

Suppose there are two shareholders in the S Corporation with different ownership percentages, both having policies with different premium commitments.
S Corporation distributions must be made in proportion to stock ownership percentages.
Example: If ownership is 60/40 and premium commitments are $10,000 and $15,000, respectively, adjustments must be made:
- To fully fund the $15,000 premium, the 60% owner must receive a distribution of $22,500
  (15,000 ÷ 40% × 60% = 22,500)
- That’s an extra $12,500 beyond their $10,000 premium.

A better approach might be:

Give the 60% owner a $10,000 distribution
Give the 40% owner a $6,667 distribution (10,000 ÷ 60% × 40% = 6,667)
Provide $8,333 of additional compensation to the 40% owner to bring them up to their $15,000 premium.

And that, of course, ignores payroll taxes. Yes, it gets complicated—that’s why we have accountants.

LLCs Electing to Be Taxed as Partnerships & Partners in Partnerships

LLCs have become extremely popular, and the vast majority elect to be taxed as partnerships.

(Note: An LLC can elect to be treated as a corporation—either as a C Corporation or as an S Corporation.)

Owners of these pass-through entities are different from S Corp owners
- The law does not make a distinction between the business entity and the owner.
- They cannot be employees of their businesses.
- Executive Bonus (Section 162 Plan) does not apply to them because they are not considered employees.

How Do These Owners Get Money Out of the Business?

Actually, it’s very simple:

Owners of these entities simply take distributions from their capital accounts.
These distributions are commonly called “draws”, meaning to withdraw money from one’s capital account.
Draws are not deductible—a business can write a check that isn’t deductible on the tax return.
Taking a draw does not change the business’s taxable profit.
Greater flexibility in withdrawals means these owners don’t have to deal with proportionate distribution problems like S Corporation owners do.

Owners of C Corporations

(This category also includes owners of LLCs that have elected to be taxed as C Corporations, although very few do so.)

Additional Compensation

Since the corporation is respected as a separate entity, a stockholder can be an employee.
Therefore, there is the possibility of:
- An Executive Bonus (Section 162 Plan)
- The C Corporation paying its own income tax

This means a raise in pay could generate a tax deduction in a high tax bracket while the employee/owner is in a lower tax bracket.

This is known as favorable tax arbitrage.

However, it is important to remember that:

Wages are subject to payroll taxes
Wages are subject to income tax withholding

As of 2025, the United States federal corporate income tax rate is 21%. Individual federal income tax rates range from 10% to 37%, with brackets adjusted annually for inflation. Additionally, wages are subject to a 2.9% Medicare tax, applicable to all earnings without limit.

Given these rates, the tax implications of a $50,000 bonus versus a dividend are as follows:

Bonus:

Corporate Level: The corporation deducts the $50,000 bonus, reducing its taxable income by this amount.
Individual Level: The owner includes the $50,000 bonus in their taxable income, taxed at their marginal rate.
Medicare Tax: An additional 2.9% Medicare tax applies to the bonus, totaling $1,450.

Dividend:

Corporate Level: The corporation pays taxes on the $50,000 at the corporate rate of 21%, resulting in $10,500 in taxes.
Individual Level: The owner receives the remaining $39,500 as a dividend, taxed at the qualified dividend rate of 15%, amounting to $5,925 in taxes.

In this scenario, the combined tax burden for the dividend approach is $16,425, while the bonus approach incurs taxes based on the individual’s marginal rate plus the Medicare tax. If the owner’s marginal rate is 35%, the tax on the bonus would be $17,500, plus the $1,450 Medicare tax, totaling $18,950. Therefore, in this case, paying a dividend results in a lower combined tax liability compared to paying a bonus.

It’s important to note that individual circumstances, such as varying tax brackets and state taxes, can influence the overall tax outcome. Additionally, while the Jobs and Growth Tax Relief Reconciliation Act of 2003 (JGTRRA) provided favorable tax treatment for qualified dividends, tax laws have evolved since then. As of 2025, qualified dividends are taxed at rates ranging from 0% to 20%, depending on the individual’s taxable income.

Given the complexities and potential changes in tax regulations, it’s advisable for business owners to consult with tax professionals to determine the most tax-efficient strategies for their specific situations.

In this situation, you can see that it is better for the corporation to give up its income tax deduction to get the favorable 15% tax rate on the dividend. In practice, it will have to be tested for each situation. Also, this preferential rate expires on 12/31/2012.

Collateral Assignment Split Dollar (CASD)

Let’s take a quick look at this technique. Basically, in CASD, the employer loans money to the employee, and the employee uses it to pay premiums on an individually owned life insurance policy. The employee pledges the policy as collateral for the loans—thus the name, collateral assignment split dollar.

CASD was widely promoted as a low-cost income tax leveraging device. In the early 1980s, the top income tax rate for an individual was 70%. The lowest tax rate for a corporation was 17%. With corporate rates that low and individual rates that high, it didn’t take much thought to conclude that it could be better to borrow money from your corporation’s after-tax profit than take it as additional income.

Income tax rates have changed. Corporate rates start at 15% now and top out effectively at 34%. Individual rates start at 10% and top out at 35%. The result is that there is little income tax leverage left between corporations and their owners. Why not take additional compensation (or maybe a dividend if the rates work out) and be done with it?

In addition to the simplicity of Executive Bonus, CASD loses ground on the economic benefit aspect as well. CASD was widely promoted before new Income Tax Regulations were issued by the IRS in September 2003. Under previous split dollar rules, the arrangement was treated as an employee benefit, and the employee was taxed on the value of the net life insurance coverage.

Under the 2003 Regulations, the arrangement is treated as a loan. As a loan, it is subject to §7872 IRC, which deals with interest-free loans and loans made at below-market rates. §7872 states that loans with below-market interest rates confer a valuable economic benefit, measured by the below-market-rate element of the transaction (as determined by Applicable Federal [interest] Rates, published monthly) and the terms of the loan.

Under §7872, the economic benefit is taxed to the borrower each year as additional income, called imputed interest income. It is estimated that changing from the old measure of value to the new measure of value doubled or tripled the income tax cost of CASD, significantly reducing the attractiveness of the transaction.

There are other issues with CASD as well. If the corporation does it for a period of years, a large “Loan to Stockholder” will build up on the corporation’s financial statements. It has to be repaid someday, so really all the owner is doing is deferring income tax, not avoiding it. The upshot is that although CASD is still an excellent fringe benefit for a key non-owner employee, as a tax leveraging device for the corporation’s owner, its utility is highly questionable.

Conclusions

So where does that leave the business owner who wants to get money out of the business in the most tax-efficient way? What is the best way to fund a personally owned life insurance policy that will be used as an insurance-based retirement plan to provide supplemental retirement income?

The following page contains a chart to summarize the alternatives, classified by form of organization and ownership.

The information contained herein was not intended by the author to be used, and cannot be used, by anybody for the purpose of avoiding any penalties that may be imposed on you pursuant to the Internal Revenue Code. The information contained herein was prepared to support the promotion, marketing, and/or sale of life insurance contracts, annuity contracts, and/or other products and services by Asofsp. You should seek advice from your independent legal and tax advisors to determine how the information contained here may apply to you in your particular circumstances.

Federal income tax laws are complex and subject to change. The information in this article is based on current interpretations of the law and is not guaranteed. Neither the company nor its representatives provide legal or tax advice. Please consult your attorney or tax advisor for answers to specific questions.

Before investing, clients need to understand that life insurance products:

Are not insured by the FDIC, NCUSIF, or any other federal government agency.
Are not deposits or obligations of, guaranteed by, or insured by the depository institution where offered or any of its affiliates.
Involve market risk, including possible loss of principal.

Investing involves market risk, including risk of loss of principal. Before selecting any product, please consider your clients’ objectives and needs, including cash flow and liquidity needs, and overall risk tolerance.