 What
is a Non Qualified Deferred Compensation Plan?
How
do Non Qualified Deferred Compensation Plans Work?
Deferred
Compensation Plans using Life Insurance
Company
Advantages with Deferred Compensation
Employee
Advantages with Deferred Compensation
Disadvantages
of Non Qualified Deferred Compensation
Nonqualified
Deferred Compensation and Taxes
What is a Non Qualified Deferred Compensation Plan?
Non qualified deferred compensation plans are commonly used
by companies to reward selected “highly compensated” executives
by permitting them to defer income and any income tax due
on that income until a future date. Non qualified deferred
compensation plans are chiefly used to provide additional
supplemental retirement income to key executives. They may
also provide income to the executive’s beneficiaries
if the employee dies prematurely. The company’s cost
for the plan is minimal and may be funded with a cash value
life insurance policy that is purchased by the company for
the benefit of a key employee.
How do Non Qualified Deferred Compensation Plans Work?
| 1. |
In a typical deferred
compensation plan, the company and the key employee enter
into an agreement to defer a portion of the employee’s
current income in return for future compensation, usually
in the form of retirement benefits. The deferral election
must be made prior to the end of the previous tax year |
| |
|
| 2. |
At retirement, disability, death or
other separation of employment the executive or his or
her named beneficiary receives the benefit as described
in the agreement. At the time of distribution, benefits
are considered ordinary income to the recipient. At that
point, the payment of benefits is tax deductible to the
company. |
| |
|
| 3. |
Funding and payment of benefits is
at the discretion of the company. Any informal funding
is subject to the claims of the creditors of the company.
|
Deferred Compensation Plans Using Life Insurance
Cash value life insurance is an excellent vehicle to informally
fund a nonqualified deferred compensation plan. Life insurance
is unique in that it can provide death benefits prior to
retirement and tax deferred cash value accumulation for retirement
income. In a non qualified deferred compensation plan using
life insurance, the company owns and is the beneficiary of
the policy on the key employee’s life. It pays the
premiums using the employee’s deferrals and controls
the policy’s cash value.
Company Advantages with Deferred Compensation Plans
| 1. |
Non qualified deferred
compensation plans are relatively simple to implement.
Requirements are a written plan document and a notification
to the Department of Labor. No other IRS reporting is
required. |
| |
|
| 2. |
They are excellent tools business
owners or employers can use to retain and reward key
employees. |
| |
|
| 3. |
Companies can selectively choose plan participants. |
| |
|
| 4. |
There is no direct cost to the employer
since it can be funded entirely by employee dollars.
The company can contribute partially or fully to the
plan as well. |
Employee Advantages with Deferred Compensation Plans
| 1. |
Nonqualified deferred
compensation plans provide an additional source of retirement
income for the key executive on top of any existing qualified
retirement plans. |
| |
|
| 2. |
The employee’s income deferral
reduces their current income tax liability until retirement
when they may be in a lower tax bracket. |
| |
|
| 3. |
May provide pre-retirement death benefits
if agreed to in the plan. |
Disadvantages of Non Qualified Deferred Compensation
There are two primary areas of concern with non qualified
deferred compensation plans:
| 1. |
The company does not get
an immediate tax deduction on the premium payments. The
deductions come for the business when plan benefits are
paid to participant. |
| |
|
| 2. |
The cash value build up that accumulates
inside the life insurance policy used to fund the deferred
compensation plan is subject to the creditors of the
company and is not protected from the insolvency of the
company. There are ways to protect against the effects
of managerial changes on the plan but if the company
is financially bankrupt there is no benefit protection. |
Nonqualified Deferred Compensation and Taxes¹
When using life insurance to fund a non qualified deferred
compensation plan, there are several tax considerations:
| 1. |
A portion of the executive’s
current income will be deferred thereby reducing current
income taxes. |
| |
|
| 2. |
When deferred benefits are paid to the key employee or his or her beneficiaries,
the company can deduct the amount of the benefit payments. |
| |
|
| 3. |
All benefits received by the key employee
or his or her beneficiaries are taxable as ordinary income. |
| |
|
| 4. |
Premium payments made by the company
with the employee’s deferral are not tax deductible
until future benefits are paid. |
¹ This information
is for illustrative purposes only. MEG Financial and its
representatives are
in no way providing
tax or legal advice. Please consult your CPA or tax attorney
for any questions on the taxes as they relate to your specific
circumstances.
Other Executive Compensation
Strategies:
|
