Insurance Based Retirement Plan: Funding It for the Business Owner
Looking for a tax-efficient way to save for retirement as a business owner? An insurance based retirement plan — sometimes called an insured retirement plan (IRP) — can offer more flexibility than qualified plans, without the contribution caps or heavy administrative burden.
For business owners in Fort Myers and across Southwest Florida, choosing the right retirement funding strategy is one of the most important — and most complex — financial decisions they’ll make.
Why Business Owners Look Beyond Qualified Plans
One of the biggest challenges for a successful business owner is finding the most tax-efficient way to save for retirement.
- Qualified plans offer tax-deductible contributions, but come with contribution limits, may require funding for employees the owner doesn’t want to include, and carry significant administrative and regulatory costs.
- Nonqualified deferred compensation plans seem attractive at first because of their flexibility — but that appeal fades once the owner realizes there’s no current income tax deduction for contributions.
What Is an Insurance Based Retirement Plan?
Personally owned variable universal life retirement planning is an attractive vehicle for cash accumulation, largely because of the ability to invest in equity-based sub-accounts. These underlying investment options aren’t publicly traded mutual funds — they’re only available through variable life insurance policies issued by life insurance companies.
Beyond equity-based sub-account access, this cash value life insurance retirement strategy offers:
- Potential tax-deferred growth inside the policy
- Tax-preferred access to internal policy values
- The ability to supplement retirement income
Access typically works through a series of partial surrenders to recover basis, then switching to policy loans once the cost basis is recovered. This allows the policy owner to generate cash flow without creating taxable income — the core idea behind what’s known as the insurance based retirement plan, sometimes referenced as a 7702 tax free retirement plan because it’s structured under IRC Section 7702.
Asofsp’s Overloan Protection Rider and Automated Income Monitor can make this strategy even more attractive by helping guard against unwanted lapses.
Important Tax Rules to Understand
This strategy assumes the contract qualifies as life insurance under Internal Revenue Code (IRC) Section 7702, and is not a modified endowment contract (MEC) under IRC Section 7702A.
- As long as the contract meets non-MEC definitions, most distributions are taxed on a first-in/first-out basis.
- Loans or partial withdrawals reduce the death benefit paid to beneficiaries.
- Surrender charges may apply to partial withdrawals.
- MEC loans and withdrawals are generally taxed last-in/first-out and may carry a 10% penalty if taken before age 59½.
- Loans and withdrawals combined with market performance can require additional premium to prevent a policy lapse. If a lapse occurs, loans exceeding basis are taxed as ordinary income in the year of lapse.
How to Get Money Out of the Business to Fund the Policy
The right approach depends heavily on your business structure. Tax-efficient ways of extracting money from pass-through entities look very different from those available to C Corporations — and the simplest approach is often the best.
Ways to Get Money Out:
| Business Type | Method |
|---|---|
| S Corporation owners | S corporation distributions |
| Partnerships & LLCs | Capital distributions |
| C Corporation owners | Additional compensation or dividends |
We’ll also look at Collateral Assignment Split Dollar (CASD), a technique once considered highly tax-efficient for C Corporation owners.
S Corporation Owners: Why a Raise Doesn’t Work
Because an S Corporation is legally separate from its owner, the owner can also be an employee. This leads many people to assume that giving the owner a raise — additional compensation — is a good way to fund a policy.
This raise-in-pay approach is known as an Executive Bonus, or Section 162 Plan, named for IRC Section 162, which allows businesses to deduct “ordinary and necessary” expenses, including “reasonable compensation.”
In practice, though, a raise rarely makes sense — especially for a 100% S Corporation owner.
Table One below shows a simplified example of the effect a $50,000 year-end bonus has on the owner’s individual taxable income. (This example is hypothetical and not meant to represent a specific client situation.)
| Table One: Effect of a $50,000 Bonus on the S Corporation Owner’s Personal Taxable Income | Without Bonus | With Bonus |
|---|---|---|
| S Corporation’s IRS Return | ||
| Profit before owner’s compensation | 500,000 | 500,000 |
| Owner’s regular compensation | 200,000 | 200,000 |
| Owner’s bonus | 0 | 50,000 |
| Total owner’s compensation | 200,000 | 250,000 |
| Profit reportable on owner’s individual income tax return | 300,000 | 250,000 |
| Owner’s Individual IRS Return | ||
| Compensation from S Corporation | 200,000 | 250,000 |
| Profit from S Corporation | 300,000 | 250,000 |
| Owner’s individual taxable income | 500,000 | 500,000 |
Even with a $50,000 bonus, the owner’s total individual taxable income doesn’t change — it’s simply reclassified from S Corp profit to compensation.
One factor the example leaves out: payroll taxes. The 2.9% Medicare tax applies to all wages, with no cap. So a $50,000 bonus would actually reduce overall net income by $1,450 (2.9% of $50,000) in added Medicare tax. In this example, the owner’s wages were no longer subject to Social Security tax; if they had been, the added cost could have reached $6,200 (12.4% combined employer/employee Social Security tax on $50,000).
The Solution: S Corporation Distributions
For most S Corporation owners, the better answer is an S Corporation distribution.
What is an S Corporation distribution? Technically, it’s a dividend — but unlike dividends from publicly traded companies, S Corporation profits are only taxed once, at the shareholder level.
- Shareholders are taxed when profit is earned, not necessarily when cash becomes available.
- When that profit is later distributed, it’s generally not additionally taxable.
- Most S Corp shareholders use these distributions to pay the income tax owed on their share of the company’s profits.
Limitations With Multiple Shareholders
Things get more complex with two or more shareholders, since distributions must be made in proportion to ownership percentage.
Example: Two shareholders own 60% and 40% of the company, with premium commitments of $10,000 and $15,000, respectively.
- To fully fund the $15,000 premium through proportional distributions alone, the 60% owner would need to receive $22,500 (15,000 ÷ 40% × 60%) — $12,500 more than their own premium requires.
- A better approach:
- Give the 60% owner a $10,000 distribution
- Give the 40% owner a $6,667 distribution (10,000 ÷ 60% × 40%)
- Provide $8,333 of additional compensation to the 40% owner to reach their $15,000 premium
And that’s before factoring in payroll taxes — which is exactly why business owners typically work with an accountant on this piece.
LLCs and Partnerships: A Simpler Path
LLCs have become extremely popular, and most elect to be taxed as partnerships. (Note: an LLC can also elect C Corporation or S Corporation tax treatment.)
Owners of partnerships and partnership-taxed LLCs are treated differently under the law:
- The law doesn’t separate the business entity from its owners the way it does for corporations.
- These owners cannot be employees of their own business.
- Executive Bonus (Section 162 Plan) doesn’t apply, since they aren’t considered employees.
How do these owners get money out? Simply:
- They take distributions from their capital accounts, commonly called “draws.”
- Draws are not tax-deductible to the business.
- Taking a draw doesn’t change the business’s taxable profit.
- Because there’s more flexibility here, these owners avoid the proportionate-distribution complications S Corporation owners face.
C Corporation Owners: Compensation vs. Dividends
C Corporation owners (and the rare LLC that elects C Corporation taxation) face a different set of choices.
Because the corporation is a separate legal entity, a stockholder can be an employee — opening the door to an Executive Bonus (Section 162 Plan), where the corporation deducts the bonus at its own tax rate while the owner is taxed at their individual rate. This is known as favorable tax arbitrage.
Keep in mind:
- Wages are subject to payroll taxes
- Wages are subject to income tax withholding
C Corporation Tax Rates: Then and Now
Historically, C Corporations were taxed at graduated rates. For reference, here is that older rate structure:
| C Corporation Income Tax Rates (Pre-2018) | Tax Rate |
|---|---|
| $0 – $50,000 | 15% |
| >$50,000 – $75,000 | 25% |
| >$75,000 | 34% |
A 5% surtax applied at $100,000 until the benefit of the 15% and 25% brackets was phased out; after that, the rate was a flat 34%. Rates increased further for taxable income over $10,000,000, and Personal Service Corporations were taxed at a flat 35%.
This structure no longer applies. Since the Tax Cuts and Jobs Act took effect, the federal corporate income tax rate has been a flat 21%. Individual federal income tax rates currently range from 10% to 37%, with brackets adjusted annually for inflation. Wages also remain subject to a 2.9% Medicare tax on all earnings, with no cap.
Bonus vs. Dividend: A Side-by-Side Comparison
Using current rates, here’s how a $50,000 bonus compares to a $50,000 dividend for a C Corporation owner:
| Pay a Dividend | Amount |
|---|---|
| Corporation’s taxable income | 50,000 |
| Less income tax at 15%* | -7,500 |
| After-tax income | 42,500 |
| Dividend to owner | 42,500 |
| Tax on dividend @ 15% | -6,375 |
| Net to owner after taxes | 36,125 |
| Pay Additional Compensation | |
| Additional compensation | 50,000 |
| Medicare tax @ 2.9% | -1,450 |
| Individual income tax @ 35% | -17,500 |
| Net to owner after taxes | 31,050 |
This example reflects the historical 15% corporate rate used in the original illustration. Under current law, the flat 21% corporate rate would change the dividend-path math — the corporation would owe $10,500 in tax on $50,000, leaving $39,500 to distribute. Taxed at a 15% qualified dividend rate, that’s $5,925 in individual tax, for a combined tax burden of $16,425. Compare that to the bonus path: at a 35% marginal rate plus the 2.9% Medicare tax, the combined cost is $18,950.
Bottom line: In many cases, it’s more tax-efficient for the corporation to give up its deduction in exchange for the lower qualified dividend rate on the individual side — but this must be tested for each specific situation, since tax brackets, state taxes, and individual circumstances all play a role. Business owners should work with a tax professional to confirm which approach fits their situation.
Collateral Assignment Split Dollar (CASD): Still Worth Considering?
Collateral Assignment Split Dollar (CASD) is a technique where the employer loans money to the employee, who uses it to pay premiums on an individually owned life insurance policy. The employee pledges the policy as collateral for the loan — hence the name.
CASD was once widely promoted as a low-cost income tax leveraging tool. In the early 1980s, top individual tax rates reached 70%, while the lowest corporate rate was 17% — a gap wide enough to make borrowing from corporate after-tax profits clearly advantageous over taking additional income.
That gap has largely closed. With a flat 21% corporate rate and individual rates topping out at 37%, there’s little income tax leverage left between corporations and their owners. For many owners, additional compensation — or a dividend, depending on the numbers — is simpler and just as effective.
CASD also lost ground after the IRS issued new split-dollar regulations in September 2003:
- Before 2003: The arrangement was treated as an employee benefit, and the employee was taxed only on the value of the net life insurance coverage.
- After 2003: The arrangement is treated as a loan under IRC §7872, which governs interest-free and below-market-rate loans. The below-market element is taxed to the borrower annually as imputed interest income — estimated to have doubled or tripled the income tax cost of CASD.
Other drawbacks include:
- A growing “Loan to Stockholder” balance builds up on the corporation’s financial statements over time and must eventually be repaid — meaning CASD defers income tax rather than avoiding it.
While CASD can still be a strong fringe benefit for a key non-owner employee, its value as a tax-leveraging tool for a business owner is now highly questionable.
Choosing the Right Funding Strategy: A Summary
So where does this leave a business owner who wants to fund a personally owned life insurance policy as an insurance based retirement strategy?
The table below summarizes the alternatives by business structure and ownership:
| Form of Organization | Potential Solution | Evaluation |
|---|---|---|
| C Corporation Owners | Split Dollar | Less advantageous than before; tax leverage decreased. May not be worth it. |
| Executive Bonus | Probably a good choice; simple, with some tax rate leverage possible. | |
| Dividends | Maybe — depends on current tax rates. | |
| S Corporation owned by one person | Executive Bonus | No — added Medicare tax. |
| S Corporation Distributions | No income tax advantage, but no Medicare tax. | |
| S Corporation owned by more than one person | Executive Bonus | No income tax advantage and subject to payroll taxes, but may be necessary to equalize distributions. |
| S Corporation Distributions | No income tax advantage, but no payroll taxes. | |
| LLC Members and Partners in Partnerships | Distributions of member/partner capital | The only choice — no employer/employee relationship. |
For business owners in Fort Myers and Southwest Florida, the right choice depends on your entity structure, ownership split, and long-term retirement income goals. A fee-only fiduciary advisor can help you weigh these options against your specific numbers before funding a policy.
Frequently Asked Questions
What is an insurance based retirement plan?
An insurance based retirement plan uses a personally owned variable universal life insurance policy for tax-deferred cash accumulation and tax-preferred access to those values later, typically through a combination of partial surrenders and policy loans, to supplement retirement income.
Why is it sometimes called a 7702 tax free retirement plan?
The strategy relies on the policy qualifying as life insurance under IRC Section 7702 and not being classified as a modified endowment contract (MEC) under Section 7702A — this is what allows for tax-preferred access to policy values.
How does an S Corporation owner best fund the policy premiums?
Generally through S Corporation distributions rather than additional compensation (a bonus), since a bonus adds Medicare tax without changing the owner’s overall taxable income.
Can LLC members and partners take an Executive Bonus?
No. Because they aren’t considered employees of the business, LLC members taxed as partnerships and partners in partnerships typically fund premiums through capital account draws instead.
Is Collateral Assignment Split Dollar still a good strategy for business owners?
It’s largely lost its tax advantage for owners since 2003 IRS regulation changes and the narrowing gap between corporate and individual tax rates. It can still work well as a benefit for a key non-owner employee.
What happens if a life insurance policy funding this strategy lapses?
If the policy lapses, any outstanding loan balance in excess of basis becomes taxable as ordinary income in the year of the lapse.
This information is not intended to be used, and cannot be used, for the purpose of avoiding penalties that may be imposed under the Internal Revenue Code. It was prepared to support the promotion and marketing of life insurance and annuity contracts and other products and services by Asofsp. Please consult your independent legal and tax advisors regarding how this information applies to your specific circumstances.
Federal income tax laws are complex and subject to change. This article reflects 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 should understand that life insurance products are not insured by the FDIC, NCUSIF, or any other federal government agency; are not deposits or obligations of, and are not guaranteed or insured by, the depository institution where offered or any of its affiliates; and involve market risk, including possible loss of principal. Please consider your clients’ objectives, needs, cash flow, liquidity requirements, and overall risk tolerance before selecting any product.
