Section 162 Executive Bonus Plans: Tax-Deductible Retirement Benefits for Business Owners

How Section 162 Executive Bonus Plans Work

The Section 162 executive bonus plan takes its name from IRC Section 162, which allows businesses to deduct ordinary and necessary compensation expenses including bonuses paid to employees. The structure is simple: the business pays an additional bonus to a selected employee, but instead of paying the bonus in cash, it directs the payment to an insurance company as the premium on a life insurance policy the employee owns personally. The bonus is taxable income to the employee - just like any other compensation. The employee receives a W-2 showing the additional income, and they owe federal and state income tax on it. However, the business receives a full deduction for the bonus as a compensation expense. Unlike key-person insurance (where the business owns the policy and receives no deduction), the Section 162 structure provides a deduction because the employee, not the business, is the ultimate beneficiary of the premium payment. The employee owns the policy personally and is the named beneficiary's designator. This means the policy is portable - if the employee leaves the company, they take the policy with them and can continue paying premiums out of pocket. The business has no continuing interest in the policy after the bonus period ends (unless a double-bonus structure or repayment agreement is in place).

The Double-Bonus Structure for Maximum Employee Benefit

A basic Section 162 bonus plan leaves the employee with a tax bill on the bonus. Some plans use a double-bonus structure to make the employee whole on that tax cost. In the double-bonus variation, the business pays two bonuses: one to cover the insurance premium and a second to cover the employee's estimated income tax on the first bonus. Both bonuses are deductible compensation to the business. The employee ends up with the full premium funded by the employer without a net out-of-pocket tax cost. For example: the business pays $20,000 toward the insurance premium and an additional $8,800 to cover the employee's 44% combined federal and state income tax on the $20,000. The business deducts $28,800 total. The employee reports $28,800 of additional income, pays $12,672 in tax (44% of $28,800), and nets a premium payment of $20,000 with zero personal cash outflow - funded entirely by employer bonuses. The double-bonus approach is more expensive for the business but dramatically more attractive to the employee. It is commonly used when the business is competing for executive talent or when the employee's personal cash flow makes out-of-pocket tax payments on the bonus an obstacle.

Tax Deductibility and ERISA Considerations

One of the most attractive features of the Section 162 bonus plan is that it is not governed by ERISA (the Employee Retirement Income Security Act). ERISA governs qualified retirement plans like 401(k)s and requires nondiscrimination testing - plans must cover a broad base of employees and cannot disproportionately favor highly compensated employees. This limits how much value can be concentrated in top performers. A Section 162 plan is exempt from these restrictions because it is simply a bonus arrangement, not a qualified retirement plan. The business can offer it to any employee it chooses - or even to a single employee - without triggering nondiscrimination requirements. It can be offered to the CEO and no one else, or to the three top revenue generators, without any obligation to extend it to lower-level employees. This selectivity is a key competitive advantage of the Section 162 structure. Businesses can target retention benefits precisely at the individuals they most want to keep, at amounts they choose, without compliance costs or coverage mandates that come with formal retirement plans. Deductibility requires that the total compensation to the employee - including all salary, bonus, benefits, and this insurance premium - be reasonable in the context of the services provided. For executives earning market-rate compensation, adding an insurance premium to their total package typically remains within reasonable bounds. Documentation of the total compensation analysis and business purpose is good practice.

• Section 162 plans are selective - no nondiscrimination testing, no ERISA coverage requirements
• The premium bonus is a deductible compensation expense to the business and taxable income to the employee
• The employee owns the policy personally and takes it with them if they leave - no vesting schedule required unless the plan includes a repayment agreement
• Consider a double-bonus structure to cover the employee's income tax on the bonus, making the benefit fully employer-funded from the employee's perspective
• Document total compensation reasonableness to support the deduction in the event of IRS scrutiny
• A vesting agreement or repayment covenant can be added to retain the employee for a specified period, though the employee still owns the policy

The IUL as the Policy Vehicle

Section 162 plans work with any life insurance type, but Indexed Universal Life is frequently used because of its cash value accumulation potential relative to premium cost. Whole life provides guaranteed cash value growth but at relatively modest rates. Term life provides no cash value at all - it is pure death benefit coverage with nothing accumulating for retirement. Variable universal life provides growth potential but subjects cash value to market losses without a floor. An IUL with a 0% floor and index-linked growth provides the balance that makes it well-suited for executive bonus plans: the death benefit protects the employee's family, and the cash value accumulates over the years of employer-funded premiums. After 20 to 25 years of a $20,000 annual premium, the accumulated cash value in a well-designed IUL can be substantial enough to supplement retirement income through policy loans. Those policy loans are tax-free and do not appear in MAGI. A retiring executive drawing $50,000 per year in policy loans from an employer-funded IUL receives that income with zero income tax, zero Social Security taxation impact, and zero IRMAA exposure. For an executive already receiving pension income or significant Social Security benefits, the IUL loan income keeps those sources from being taxed at higher rates.

Comparing Section 162 to a Salary Increase

From a business perspective, a Section 162 bonus plan and a salary increase have similar before-tax economics - both are deductible compensation. The difference is in what the employee receives. A $20,000 salary increase in the 32% bracket results in the employee netting approximately $13,600 after federal income tax (before state). The employee can choose to save or spend that $13,600 however they wish, including putting it into a personal IUL policy - but they bear the full responsibility for funding and maintaining it. A $20,000 Section 162 bonus applied directly to an IUL premium means $20,000 goes to the policy, the employee pays income tax on the $20,000 bonus from other funds (or receives a double-bonus to cover it), and the full $20,000 lands in the policy every year. No decision-making required. No risk of the employee redirecting the money elsewhere. No reduction from the employee's other savings discipline. From a talent retention perspective, the Section 162 plan is more structured and durable than a salary increase. The benefit is visible, quantifiable, and grows over time. Executives can see the cash value building in a policy they personally own. This visibility and permanence often makes the Section 162 plan more valued by recipients than an equivalent salary addition.