If you’ve been researching ways to reward a key employee without offering equity or setting up a complicated retirement plan, you’ve probably come across the term “Section 162 executive bonus plan.” It sounds technical, but the concept behind it is fairly simple once you break it down. This guide covers the basics: what the plan actually is, how it works, who typically uses it, and why it’s remained a popular strategy for decades.

The Basic Concept

A section 162 bonus plan is named after Section 162 of the Internal Revenue Code, which governs ordinary and necessary business expenses, including employee compensation. In this arrangement, a business pays a bonus to a key employee, and that employee uses the bonus to pay premiums on a permanent life insurance policy that they personally own. The business deducts the bonus as a compensation expense, and the employee receives a life insurance policy with a death benefit and accumulating cash value, funded through what is essentially additional pay.

Why It’s Called an “Executive Bonus” Plan

The name reflects how the benefit is delivered — as a bonus, rather than through a retirement plan contribution, a stock grant, or a deferred compensation promise. This distinction matters because a bonus, unlike a qualified retirement plan contribution, isn’t subject to contribution limits, nondiscrimination testing, or ERISA reporting requirements. The business has full discretion over who receives the bonus and how much, which is exactly why the strategy is so commonly used for a specific executive or a small group of key people rather than the entire workforce.

Who Typically Uses This Strategy

Section 162 plans show up most often in closely held and mid-sized businesses — companies that want to reward a specific person (a top salesperson, an operations leader, a co-owner’s successor) without extending the same benefit company-wide. They’re also common among businesses that have already maxed out contributions to a 401(k) for a highly compensated employee and want an additional benefit that isn’t capped by the same limits. Physicians’ practices, law firms, and other professional service businesses use the strategy frequently, since these businesses often have a small number of highly compensated key people they specifically want to retain.

How the Life Insurance Piece Works

The policy at the center of the plan is typically a form of permanent life insurance — whole life, universal life, or indexed universal life — chosen because these policy types build cash value over time in addition to providing a death benefit. Term life insurance, by contrast, doesn’t accumulate cash value and is rarely used in this structure, since part of the appeal to the employee is the growing asset the policy represents, not just the death benefit protection. The employee is the owner and typically the insured, and they name their own beneficiary, just as they would with any personally owned life insurance policy.

The Tax Treatment in Simple Terms

The business deducts the bonus as a normal compensation expense, the same way it would deduct a salary payment, as long as the total compensation (salary plus bonus) is considered reasonable for the work performed. The employee reports the bonus as taxable income, typically through payroll, meaning it’s subject to the same income tax withholding as any other bonus. Some businesses choose to pay a “double bonus,” adding extra funds specifically to offset the tax the employee will owe on the original bonus, so the net cost of the premium to the employee is minimized.

Restricted vs. Unrestricted Plans

There are two basic versions of this strategy. In an unrestricted plan, the employee owns the policy outright from the start, with no strings attached — if they leave the company the next day, they keep the policy. In a restricted version, called a Restricted Executive Bonus Arrangement (REBA), the business places an endorsement on the policy that limits the employee’s access to its cash value until they’ve met a vesting condition, usually a minimum number of years of continued employment. This restricted version is what gives the strategy real retention power, since it creates a financial incentive to stay.

Why Businesses Choose This Over Other Options

Compared to alternatives like deferred compensation or a supplemental executive retirement plan (SERP), a section 162 executive life insurance plan is simpler to set up and administer, doesn’t create an unfunded liability on the company’s books, and gives the employee immediate, tangible ownership of an asset (unless restricted). It’s not the right fit for every situation — businesses wanting to benefit a large group of employees, or that need the deeper retention lock-in of unfunded deferred comp, may look elsewhere — but for straightforward, selective executive rewards, it remains one of the most commonly used strategies available.

At its core, this is a strategy about flexibility: rewarding the people who matter most to your business, on your own terms, using a benefit that combines a business tax deduction with a real, lasting asset for the employee.

Frequently Asked Questions

Is a Section 162 plan a type of retirement plan?

No. It’s a compensation arrangement built around life insurance, not a qualified retirement plan. It isn’t subject to the contribution limits or nondiscrimination testing that apply to plans like a 401(k), though the policy’s cash value can informally serve a supplemental savings role.

Can any business set up a Section 162 plan?

Generally yes — this strategy is available to businesses of virtually any size or entity type, from sole proprietorships to C corporations, though the tax mechanics can vary slightly by entity structure.

Does the employee have to be a top executive?

No. Despite the name, the strategy can be used for any key employee the business wants to reward — a top salesperson, a critical operations manager, or any employee whose retention or performance matters significantly to the business.

How is this different from just giving someone a raise?

A raise is straightforward additional pay with no strings or structure attached. A Section 162 plan directs that additional pay specifically into a life insurance policy, which builds a permanent asset with a death benefit and cash value, and can optionally include retention conditions a simple raise doesn’t provide.

Is the life insurance policy owned by the business or the employee?

The employee owns the policy in a standard Section 162 arrangement, which is what distinguishes it from key person insurance, where the business is both owner and beneficiary.

Do I need special IRS approval to set up this kind of plan?

No formal IRS approval or filing is required to establish a Section 162 plan, unlike qualified retirement plans. Proper documentation — a written bonus agreement and appropriate payroll treatment — is what supports the plan’s tax treatment if it’s ever reviewed.