Module 4 — Group Carve-Out Plans

Employer-sponsored group term life insurance has grown from its origins in the early 20th century to an in-force level of more than four trillion dollars, accounting for more than 40 percent of all life insurance in the United States. It is an expected employee benefit and often the only life insurance carried by many breadwinners.

Group carve-out plans augment this important benefit by purchasing additional coverage — usually in the form of universal life policies — on the lives of key personnel. Upon completion of this module, you should understand how the group carve-out plan:

• Enables key executives to overcome group term life insurance limitations arising from nondiscrimination requirements
• Makes formerly non-portable life insurance coverage fully portable and continuable beyond retirement
• Enables key executives to avoid Table I imputed income costs for group term coverage in excess of $50,000
• Allows policy cash values to grow tax-deferred and be accessed for additional retirement income

Group life insurance serves the same function as individual insurance — a beneficiary receives death proceeds when a covered member dies. It has a number of distinct features compared to individual coverage:

• Single master policy covers the entire group with no individual underwriting
• Lower overall costs due to reduced administrative, operational, and selling expenses
• No individual selection of benefits — schedules are predetermined to prevent adverse selection
• Minimum participation standards — typically 75% of eligible employees for contributory plans; 100% for noncontributory
• Rates based on group stability — not the individual insured’s age or health

Coverage amounts are established by a schedule of benefits included in the group policy and must conform with state law limits. New employees must satisfy a probationary period (usually 30–90 days) before enrolling, then have 31 days to enroll. Those applying later generally must submit proof of insurability.

Beneficiaries may be anyone the insured designates. Conversion privilege allows an individual to convert group coverage to an individual permanent policy upon leaving the group, though premiums may be very high at advanced ages. A growing trend is portable group term, allowing employees to take their term coverage — though without cash value — when they leave.

31-day continuation of coverage applies if the insured dies within 31 days of terminating employment. Many plans also include a waiver of premium for totally disabled employees and benefit reduction formulas for older or retired employees.

Group Term Life is by far the most common — annually renewable term with no cash value accumulation. Group Paid-Up Life uses a combination of accumulating whole life units and decreasing term, resulting in a declining cost to the employer and portable paid-up coverage for the employee. Group Universal Life (GUL) is paid by the employee at group rates (usually via payroll deduction), issued without evidence of insurability up to certain limits, and provides permanent protection with flexible cash value accumulation.

Section 79 of the Internal Revenue Code governs the tax treatment of group life insurance:

• The cost of the first $50,000 in employer-provided group term life insurance is not taxable to the employee
• Coverage in excess of $50,000 creates taxable income to the employee, valued using Table I rates (which may be higher than actual costs)
• Employer premiums are deductible as reasonable business expenses; employee premiums are not deductible but may offset the Table I amount
• Death benefit proceeds are received income tax-free by the beneficiary; interest on installment payments is taxable
• Retired employees continuing group term coverage are taxed the same way as active employees

Group carve-out plans are designed to overcome the four significant limitations inherent in group term life insurance:

• Coverage must be nondiscriminatory. A discriminatory group term plan causes key employees to lose the $50,000 exclusion, and the employer’s premium may become taxable income to participants.
• Coverage is adversely affected at retirement. Group term coverage is usually reduced or eliminated at retirement. Converting at an advanced age results in very high premiums at precisely the time income has decreased.
• Coverage is lost upon termination. Group term is not portable — when the executive leaves the employer, the coverage ceases.
• Table I costs over $50,000 are taxable. Employees must report the IRS-imputed value of group term coverage exceeding $50,000 as taxable income. Table I rates are often higher than actual insurance costs.

In a group carve-out plan, the employer replaces existing group term life insurance coverage in excess of $50,000 with individual universal life insurance policies on selected executives. The remaining $50,000 of group term coverage stays in place. The universal life policy may be declared rate, equity-indexed, or variable, depending on the executive’s risk tolerance.

The employer continues paying premiums for both the remaining group term coverage and the universal life policy. The universal life minimum premium typically approximates the cost of an equal amount of group term insurance, so there is generally no cost increase to the employer.

Universal life (UL) unbundles the insurance, savings, and expense components. A mortality charge (increasing with age) is deducted monthly from the cash value account; the remainder earns interest at either the current credited rate or the guaranteed minimum. The policyowner can:

• Vary premium payments (flexibility for employers with seasonal cash flow)
• Increase or decrease face amounts (usually with evidence of insurability)
• Make partial cash value withdrawals (unlike whole life, which only allows loans or full surrender)
• Choose between two death benefit options: face amount only (option one), or face amount plus cash value (option two)

There are five principal advantages that inure to the employer that installs a group carve-out plan:

• Reduction in Discrimination Concerns.
  The carve-out removes executives’ coverage in excess of $50,000 from the group plan, eliminating the nondiscrimination concern for the employer while preserving the base $50,000 group term coverage for all employees.
• No Cost Increase (Possible Cost Decrease).
  The universal life minimum premium typically approximates the cost of the same amount of group term. By removing older executives from the census for amounts over $50,000, the average age per $1,000 may actually decrease — potentially lowering overall group term rates.
• Ability to Limit Participation.
  The employer can provide significantly increased life insurance to selected executives without affecting the nondiscrimination status of the base group plan.
• Current Employer Tax Deduction.
  The employer receives a current income tax deduction for the entire premium paid for both the group term life insurance and the employee-owned universal life insurance policy. The group term life insurance premium is deductible as an employee benefit, and the employer-paid portion of the universal life insurance policy premium is deductible to the employer as compensation. Accordingly, the premium for the universal life insurance policy is included in the executive’s income for tax purposes — just as the Table I costs would be if the entire life insurance coverage were provided under the group policy.
• Executives Encouraged to Participate.
  The UL policy’s tax-deferred growth and FIFO withdrawal treatment make additional voluntary contributions attractive, increasing executive engagement.

• Death benefits beyond retirement. Because the executive owns the universal life policy, coverage continues beyond retirement at premiums based on the executive’s age when the plan began — often far lower than conversion premiums at retirement age.
• Tax-deferred accumulation of voluntary deposits. Because the employer pays the minimum premium (covering per-policy costs), the executive’s voluntary deposits earn a return slightly higher than the credited interest rate. Over 20 years, a $6,000 annual voluntary deposit into a policy with a 6.75% crediting rate can produce approximately $282,000 in cash value by age 65, reflecting an effective 7.3% return.
• Portability. The universal life policy continues if the executive leaves the employer for any reason. The executive takes the policy and is responsible for future premiums.
• Supplemental retirement income. Through a combination of FIFO withdrawals up to basis and policy loans thereafter, the executive can receive retirement income entirely free of income taxes, provided the policy never lapses.
• Table I costs eliminated. The executive’s taxable income under the carve-out (equal to the UL premium bonused to the executive) is typically less than the Table I imputed income that would have resulted from the same amount of group term coverage.

• Executive age: 45 years old with a $500,000 group carve-out UL policy
• Employer-paid UL premium: $2,580/year — total over 20 years: $51,600 in taxable income to the executive
• Table I cost comparison: The same $500,000 kept in group term would have generated $80,700 in imputed taxable income over 20 years
• Tax savings: The carve-out saves the executive income tax on $29,100 ($80,700 − $51,600) compared to group term

An employer seeking to recover its UL premium payments may use a split-dollar approach, splitting death benefits between the employer and the executive’s beneficiary. The employer’s share equals the greater of cumulative premiums paid or the policy’s cash value; the remainder goes to the executive’s beneficiary. The employer also owns its portion of the cash value, available for business needs or to fund a special retirement benefit if the executive lives to retirement.

The employer receives a current income tax deduction for all premiums paid — group term premiums as an employee benefit, and the universal life premium as compensation to the executive. The UL premium is included in the executive’s W-2 as a bonus and is taxable as ordinary income.

The executive’s taxable income under the carve-out plan is generally less than the Table I costs that would have been incurred if all coverage had remained under the group policy. The employer-paid UL premium, though taxable to the executive, typically costs less than the age-based Table I rates applied to the same face amount.

The UL policy’s cash value grows tax-deferred. Withdrawals are taxed under FIFO treatment — basis (total after-tax premiums paid) is considered to come out first, tax-free. Once basis is recovered, policy loans can be used to avoid additional taxable income, as long as the policy is never surrendered or allowed to lapse.

If an executive objects to the taxable income created by the bonused UL premium, the employer may pay a double bonus (gross-up): the employer pays the UL premium bonus plus an additional amount equal to the executive’s income tax liability on the bonus. The result is that the executive’s after-tax cost is reduced to zero.