By Jeff Velastegui, Founder of the Legacy Group, Personal Estate & Business Advisor
Why This Keeps Coming Up in My Meetings
Whenever I sit down with a business-owner client, one thorny question always finds its way onto the agenda: “How can I reward the people who drive my growth—without drowning in ERISA red tape or blowing up the budget?”
After two decades of answering that question, a Section 162 Executive Bonus Plan still lands at the top of my simple-but-powerful list. It’s easy to set up, fully deductible, and flexible enough to fit either a family business or a multi-location operation. Let’s unpack how the strategy works, where it shines, and a few potholes to steer around.
The Strategy in One Paragraph
A Section 162 plan is as straightforward as it sounds: your company pays a bonus to a selected employee, and the employee uses that after-tax money to buy—and personally own—a permanent life-insurance policy. Section 162 of the Internal Revenue Code lets a business deduct “ordinary and necessary” compensation, so the bonus is deductible—much like salary.
Meanwhile, the employee enjoys life-insurance protection today and, over time, builds a cash-value reserve they can tap for retirement or other goals.
Follow the Cash—and the Taxes
- The company writes the check. Because the payment is compensation, the business gets a deduction in the year it’s paid.
- The employee reports income. They owe income and payroll tax on the bonus.
- The policy is funded. Premiums flow into a whole-life, indexed UL, or similar contract the employee owns outright, accumulating tax-deferred cash value and an income-tax-free death benefit (under current law).
Single vs. Double Bonus (Who Eats the Tax?)
- Single bonus: You pay exactly the premium amount; the employee covers the tax.
- Double bonus: You “gross up” the payment so the employee nets the full premium after taxes.
Quick illustration: Suppose you want Cindy, your COO, to have a $40,000 annual premium and she’s in a 35% combined tax bracket.
- Single bonus: Costs the company $40K, but Cindy forks over $14K in taxes, netting $26K—hardly ideal.
- Double bonus: Costs the company about $61,500, letting her clear the full $40K premium and wiping out the surprise tax bill.
Either route is deductible; the choice is pure cash-flow optics.
Design Levers You Control
- Pick who plays. Unlike a 401(k), Section 162 has no coverage or nondiscrimination testing. You can target one rainmaker or your entire leadership bench.
- Choose policy type and funding pace. Whole life offers guarantees and disciplined accumulation; indexed UL or VUL can chase higher upside (with more moving parts). Premiums can be level, increasing, or a one-time lump sum—whatever fits your budget.
- Add “golden handcuffs” without handcuffing yourself. If retention is the goal, attach a restrictive endorsement. This allows the employer to restrict access to the cash value to ensure the cash value builds for the intended purposes. If the company wants more control they could use a leverage bonus where the tax cost is loaned to the employee and the employee collateral assigns the policy to the employer to secure the loan.
- Keep it reasonable. The bonus must fit within what the IRS would call ordinary compensation for the role. Document why the total package aligns with market pay.
Implementation Checkpoints
- Paperwork (the light kind). Draft a one-to-three-page bonus agreement stating amounts, timing, and any restrictive endorsement language. File it with HR; no government approval needed.
- Payroll accuracy. Report the bonus (and any gross-up) on the employee’s W-2. Skipping the payroll-tax piece is the easiest audit trigger.
- Entity-type nuance. C-corps feel the deduction directly. In an S-corp or LLC, the deduction still flows, but owners see it on their K-1s, so coordinate timing with your CPA.
- Policy illustrations. Stress-test conservative returns and be sure the design still works if dividends or index credits soften. A policy that implodes at age 70 helps no one.
A Real-World Vignette
Lisa is a 45-year-old COO who has doubled a manufacturer’s revenue in three years. The owner wants her locked in for at least another decade.
- Plan: $40K annual premium for five years, plus gross-up (total outlay ≈ $56,400 per year).
- Projected outcome: At age 65, the policy is projected to hold roughly $275K in cash value and provide a $1 million death benefit—funds she can access tax-advantaged for retirement or legacy goals.
The company deducts every payment, Lisa gains valuable coverage with no out-of-pocket cost, and both sides like the retention tether. Simple, clean, deductible.
Is it a Fit—or a Misfit?
A Section 162 plan tends to shine when you:
- Need benefits beyond qualified-plan limits
- Want flexibility to reward one person without triggering benefits for all
- Prefer deductions today rather than deferred expense recognition
- Like the idea of life-insurance protection plus cash-value growth in one wrapper
It’s less compelling if your key people are already maxed out on life-insurance capacity or if your business cash flow can’t stomach multi-year premium commitments.
Next Steps
If the concept resonates, start by modeling the real after-tax dollar cost—single vs. double bonus—and sanity-check total compensation against industry benchmarks. Loop in your CPA for entity-specific nuances, and have your attorney bless the agreement language. The heavy lifting can often be wrapped up in a week or two, making Section 162 one of the quicker ways to upgrade your executive-benefits lineup.
*This hypothetical example is for illustrative purposes only. This is not a prediction or guarantee of actual results. This example is not intended to represent the value or performance of any specific product.
Any discussion of taxes is for general information purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax, or accounting advice. Clients should confer with their qualified legal, tax, and accounting advisors as appropriate.
Securities and investment advisory services offered through qualified registered representatives of MML Investors Services, LLC. Member SIPC. The Legacy Group is not a subsidiary or affiliate of MML Investors Services, LLC, or its affiliated companies. . CRN202808-9258916
