Tax Advantages of Funding a NQDC Plan Using Life Insurance

By Robert McGowan

April 10, 2023

Life insurance policies with an investment component, or “cash value,” can be an effective means of funding NQDC plan benefits. These policies can provide benefits payable at the participant’s retirement after reaching a certain age, during the participant’s disability prior to retirement, or to survivors upon the participant’s death before retirement. The cash value of the policy can be accessed by the employer to make the benefit payments when they become due.

There are several federal income tax advantages associated with using life insurance to fund NQDC plans:

  1. Deferral of income taxation: Deposits into life insurance policies and earnings on those deposits are generally not subject to current income taxation, allowing for tax-deferred growth within the policy.
  2. Tax-free policy death benefit: Assuming no transfer-for-value issues or state law insurable interest problems, the death benefit proceeds from a life insurance policy are typically received tax-free by the beneficiary, which is usually the employer in the case of NQDC plans.
  3. Deductible plan benefit payments: When the employer makes benefit payments to the employee or their beneficiaries under the NQDC plan, these payments are generally tax-deductible for the employer.
  4. Tax-free withdrawal of policy value: To pay the NQDC plan benefits, the employer can access the policy’s cash value through tax-free withdrawals as a return of basis or loans, provided that the policy is not considered a modified endowment contract (MEC).

It is important to note that there are specific federal income tax requirements that must be met to ensure the taxation of the life insurance policy aligns with the employer’s expectations. For example, the notice and consent requirements of Section 101(j)(4) of the Internal Revenue Code must be satisfied for the employer to receive the life insurance death benefit proceeds free of federal income tax.

In summary, life insurance can serve as a valuable funding mechanism for nonqualified deferred compensation plans, offering several tax advantages when used correctly. However, it is crucial to adhere to the relevant federal income tax requirements to fully realize these benefits.