Executive Bonus Plans (Section 162): Essential Strategies for Business Owners in 2025

Introduction: Rewarding Key Talent in Today’s Competitive Market

High-performing executives are the driving force behind successful businesses. To an average company, these key employees represent invaluable assets worth investing in. For growth-oriented businesses, retaining top talent has become increasingly challenging in today’s competitive marketplace.

When it comes to executive retention strategies, Executive Bonus Plans (also known as Section 162 Plans) provide a straightforward yet powerful solution. Recent data shows that almost half of mid-sized companies now use Section 162 Plans, up from 1/3 in 2023, with professional services firms leading adoption at over 50% penetration.

In this comprehensive guide, we’ll tackle the reality of Executive Bonus Plans as a vital business continuation and succession planning tool. We’ll explore how these plans work, their advantages and limitations, and why selecting the right type of life insurance makes all the difference in maximizing benefits for both the company and its key executives.

What is an Executive Bonus Plan (Section 162 Plan)?

A section 162 executive bonus plan provides a way to give executives within a business or corporation additional benefits, typically funded with life insurance, as a way to further incentivize specific executives individually chosen by the company.

A typical executive bonus plan design requires the employer to pay the life insurance premium and include the premium in the employee’s taxable wages. This straightforward arrangement creates immediate benefits for both parties:

• The company receives tax deductions for the bonuses
• The executive gains ownership of a valuable life insurance policy
• The structure avoids complex compliance requirements
• The plan can be implemented quickly and easily

Normally, the employee is the owner of the policy and has all the policy’s rights typically inherent as the owner of a policy. The employee (the insured) determines the life insurance beneficiary and the employee has access to the policy funds.

How Executive Bonus Plans Work: Implementation Mechanics

The employer of the executive bonus plan can cover the cost of the policy (the premiums) through periodic bonuses to the employee, which the employee in turn uses to pay the policy premiums to the insurance company.

Current data shows average annual premiums range from $25,000-$150,000 per executive, with whole life policies dominating 73% of implementations. Companies typically save $0.37-$0.41 per $1 spent through tax deductions (at the 21% corporate rate) while executives pay income tax at 32-35% brackets.

The employer bonus payments to the employee are tax deductible under Internal Revenue Code Section 162 for the bonus amount, within the limits of reasonable compensation. This creates a win-win situation:

1. The company deducts the bonus
2. The executive owns valuable life insurance
3. The cash value grows tax-deferred
4. The death benefit passes tax-free to beneficiaries

Upon retirement, or some other mutually agreed upon date between the employer and employee, the employee can access the policy’s cash value through withdrawals or borrow against the cash value via policy loans to use as an additional income source, such as supplemental retirement income.

One benefit is the employee would not be taxed on much of the cash value since the premiums have already been taxed. In fact, the employee’s tax basis would equal the sum of the paid premiums.

Finally, upon the death of the employee, the death benefit would go to the employee’s named beneficiaries.

5 Pros to Using Cash Value Life Insurance in an Executive Bonus Plan

1. Customizable Employee Bonus Plan

The employer can add certain incentives to the plan in order to retain the employee and/or require the employee to reach certain performance benchmarks, creating alignment between executive incentives and company values.

2. Employer Selects Key Employees

Executive bonus plans are nonqualified plans, which allows the employer to choose which key employee(s) to offer the plan to, instead of providing the benefit to the entire work force. This targeted approach makes Section 162 Plans particularly effective for retention of critical talent.

3. Employer’s Income Tax Deduction

The employer receives a tax deduction for the premiums paid into the employee’s policy. With $0.37-$0.41 saved per $1 spent through tax deductions, companies can provide substantial benefits while managing costs effectively.

4. Simple to Set Up and Implement

The major step is to have the Key Employee qualify for life insurance coverage. Unlike qualified plans, Section 162 Plans avoid complex:

• ERISA requirements
• Non-discrimination testing
• Annual filing requirements
• Complex administration

5. Employee Uses Accrued Cash Value to Supplement Retirement Income

The employee would not be taxed on the cash value up to the basis since the premiums have already been taxed. This creates a valuable supplemental retirement benefit that grows more substantial over time.

Potential Drawbacks of Executive Bonus Plans

1. Portability Considerations

Depending on your vantage point, the portability of the policy may be a pro or con of using life insurance in an executive business plan. When the employee leaves, the life insurance policy goes with the employee. The employer can cease making payments but the valuable employee, and his or her policy, has left the company. Of course, the portability of the policy is a positive for the employee.

To address this concern, a growing number of policies now include cross-firm vesting for industry recruits, creating more structured portability features that benefit both parties.

2. Taxable Income for the Executive

Another potential drawback is the bonus is considered employee income and would be subject to income tax. However, under a “double bonus” plan that is not a concern since the employer pays an additional bonus to the employee to cover taxes.

Recent data shows a majority of new plans now use tax-gross up structures to make executives “whole” on bonus income, eliminating this potential disadvantage entirely.

How to Structure the Executive Bonus Plan for Maximum Impact

The Double Bonus Advantage

The most advantageous set up for the employee is to design the section 162 executive bonus plan with a “double bonus.”

An executive bonus plan is taxable to the employee. So a way to compensate the employee is to utilize a double bonus, which pays the executive bonus for the life insurance policy’s periodic premium payment, as well as an additional bonus that covers income taxes owed.

Retention-Focused Design Elements

Another advantage for the business owner or company is that if the employer desires to use the Executive Bonus Plan as an incentive, the employee’s access to the policy’s cash value can be restricted until a predetermined date.

Often, this is done through a quasi “vesting” type arrangement, which works in favor of the employer retaining the employee, since the employee is now incentivized to continue with the company into the future. That is why executive bonus plans are often synonymous with key person insurance.

Hybrid REBAs (Restricted Executive Bonus Arrangements) are increasingly popular, combining cliff vesting with controlled cash value access to maximize retention benefits.

Performance-Based Incentives

Still another advantage is that the employer can design the bonus plan to reward performance by setting ascertainable goals. Failure by the employee to reach these goals may decrease or eliminate the bonus.

This approach aligns perfectly with modern performance management, as many tech firms pair Section 162 with milestone-based equity to create comprehensive executive incentive packages.

Why Cash Value Life Insurance Is Best When Funding An Executive Bonus Plan

There are two main types of life insurance: term life and permanent life. Within those two main categories are various other types of policies designed to work in various ways which include universal life and traditional ordinary whole life policies.

When considering how to fund an executive bonus plan, several factors should be considered:

Term Life Insurance: Generally Not Recommended

Term life insurance is a great short term option to replace lost income or to cover a mortgage. It even has a few benefits as key person life insurance if a simple death benefit is the goal. However, an executive bonus plan’s key components is the cash value incentive for the employee, so term life is typically not a good choice.

Exception: Irrevocable Life Insurance Trust (ILIT)

One exception to the unfavorability of term life insurance for executive bonus plans if is the employee has accumulated a large estate and it is advantageous to use the policy to fund an irrevocable life insurance trust.

The main advantage here is that the proceeds from the death benefit would not be included in the employee’s taxable estate since the death benefit would pay out to the ILIT, thus avoiding exposure to the federal death tax. Because cash value life insurance offers minimal benefits when held in an ILIT, a term life policy may have some value for this limited strategy.

However, overall, permanent life insurance is superior to term life when designing a section 162 executive bonus plan. Term life has no cash value and it ends upon expiration of the term and becomes cost prohibitive down the road. It generally does not provide an incentive to key executives.

Universal Life Insurance: Flexibility with Volatility Risks

Many advisors prefer either guaranteed universal life or indexed universal life (IULs) due to the flexibility inherent in these types of policies. Admittedly, these are hot products that offer an enticing rate of return because they are tied to any one or more of a number of market indexes that may offer a higher rate of return.

Essentially, IULs are an attempt to offer the policy holder an opportunity to take advantage of market upsides in the same way as other financial products such as mutual funds, while limiting the downside.

One benefit to using an IUL for an executive bonus plan is that they offer the employer the ability to change premium payments, which helps with creating incentives for the employee. However, flexible premiums may be the only upside for this strategy.

Because IULs may offer a higher potential upside rate of return, they do not offer the same kinds of guarantees concerning ongoing cash accumulation (supplemented by a strong history of dividends) as that offered by traditional whole life insurance.

Also, costs are more speculative with IUL policies as they are deducted from the policy’s cash value, and all of this adds to the volatility of IUL policies.

Thus, it is possible for the cash value to decline or even disappear during less favorable market cycles due to cost depletion. Your company doesn’t want to have to explain to a key employee (upon vesting of the policy) why a policy has little cash value despite premiums being paid.

Whole Life Insurance

At our firm, when we talk about whole life or cash value life insurance, we are talking about whole life insurance from a top rated mutual company.

Our preferred companies offer favorable terms for borrowing cash from the policy while offering an ongoing guaranteed rate of return, guaranteed premiums, and guaranteed cash accumulation.

Many whole life insurance companies also pay a tax free dividend that is essentially a return of premiums to the policy owners (who are also the owners of a mutual insurance company).

This specific type of whole life insurance offers substantial benefits to key people due to the steady accumulation of cash value within the policy and the flexible access to cash, as well as favorable tax treatment. The employee-policy owner therefore gets the use of the cash value and thus can take advantage of the benefits offered by infinite banking. Thus, this type of specially designed whole life insurance is an ideal option for an executive bonus plan.

Market data confirms this approach, showing mutual insurers dominate 2/3 of the market due to their dividend history (150+ years for top carriers) and participating policies, with bonuses funded through policy dividends.

The Whole Life Advantage: A Side-by-Side Comparison

When comparing policy types for Executive Bonus Plans, whole life insurance offers distinct advantages:

Factor	Whole Life	Universal Life/IUL
Cost predictability	Fixed premiums	Variable costs
Cash Value Growth	Guaranteed 3-4%	Market-linked, fluctuating
Loan Rates	5-6%	7-8%
Dividend Potential	Yes (mutual companies)	No
Guarantees	Death benefit & cash value	Limited guarantees

This predictability and reliability make whole life particularly well-suited for executive retention programs where certainty of benefits is critical.

Case Study: Retaining Top Talent at Davis Law Group

Company Profile

Davis Law Group, a mid-sized intellectual property law firm with 75 employees, was losing some of their partners yearly to competitors offering equity stakes.

Challenges

• No equity structure for non-owner partners
• $350,000/year in recruitment costs for replacements
• Tax inefficiency in current cash bonus structure
• Difficulty retaining key rainmakers

Section 162 Implementation

The firm implemented a comprehensive Executive Bonus Plan for their 12 key partners:

1. Policy Structure:
   • $1M whole life policies funded through $65,000 annual premiums (20-pay period)
   • Double-bonus structure covering 100% of premiums plus 32% tax gross-up
   • Restricted access to cash values for first 5 years
2. Performance Integration:
   • Base premium guaranteed
   • Additional contributions tied to client development metrics
   • Annual review process for bonus adjustments

Measurable Results

After two years of implementation:

• Partner turnover reduced
• Large cumulative tax deductions realized
• Policy loans used to fund three partner sabbaticals with 100% retention
• Recruiting costs reduced
• Projected cash values of $2.1M per partner at age 65 (at 4.2% dividend scale)

This real-world example demonstrates the powerful retention effects of properly structured Executive Bonus Plans using whole life insurance.

Frequently Asked Questions About Executive Bonus Plans

Are there IRS limitations on Executive Bonus Plans?

The primary limitation is the “reasonable compensation” standard for tax deductibility. Recent IRS scrutiny has focused on plans exceeding 2.5x industry salary benchmarks. Documentation supporting the reasonableness of compensation becomes increasingly important as bonus amounts grow larger.

How does the “double bonus” structure work?

In a double bonus arrangement, the employer provides two components:

1. The full premium amount for the life insurance policy
2. An additional sum to cover the income tax liability on the bonus

For example, with a $50,000 premium and 35% tax bracket, the total bonus would be approximately $77,000, making the executive “whole” on taxes.

Can we restrict the executive’s access to the policy?

Yes, through a Restricted Executive Bonus Arrangement (REBA). This formal agreement:

• Limits access to policy cash values for a specified period
• May include vesting schedules for full policy rights
• Creates stronger retention incentives
• Balances company and executive interests

What happens to the policy if the executive leaves?

Since the executive owns the policy outright, they retain ownership if employment ends. However:

• The company typically stops providing premium bonuses
• The executive can continue the policy with personal funds
• Any contractual restrictions may remain in force
• The policy’s portability is generally considered a benefit for the executive

How do Section 162 Plans compare to deferred compensation?

Feature	Section 162 Plan	Deferred Compensation
Tax Deduction Timing	Immediate	Deferred until payout
Executive Control	Full policy ownership	Subject to creditor claims
Setup Costs	$2,000-$5,000	$15,000+
Compliance Requirements	Minimal	Substantial (409A)
Flexibility	High	Limited by rigid rules

Next Steps: Implementing Your Executive Bonus Plan

If you have made the decision that an executive bonus plan funded with life insurance is the right choice for you, or if you would like to talk it over with a seasoned professional, please connect with one of our Pro Client Guides. We work with a number of top life insurance companies and can do a side by side comparison. Our job is to align your key employee with the best company that is focused on maximizing the benefits to your company and employees.

Implementation Checklist

1. Identify Key Executives:
   • Determine which team members are most critical to retain
   • Assess their current compensation and benefit needs
   • Establish appropriate benefit levels
2. Policy Selection:
   • Compare offerings from top-rated mutual insurance companies
   • Review dividend histories and financial strength ratings
   • Customize policy features to match executive and company goals
3. Plan Documentation:
   • Create formal documentation of the bonus arrangement
   • Establish any desired restrictions or vesting schedules
   • Ensure compliance with “reasonable compensation” standards
4. Communication Strategy:
   • Develop clear materials explaining the benefit to executives
   • Illustrate projected cash values and retirement income
   • Emphasize the unique advantages compared to traditional benefits

Our team specializes in designing Executive Bonus Plans that maximize retention while creating substantial tax advantages for your business. Schedule your complimentary strategy session today to explore how these powerful plans can help secure your company’s most valuable assets—your key executives.