Smart companies realize the significance of providing competitive compensation packages to their executives and key employees. In fact, studies show that the chief reason why executives leave companies is compensation. A non qualified deferred compensation plan is a strategy companies use to provide additional supplemental benefits to their key people.
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?
- 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
- 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.
- 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 non-qualified 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
- 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.
- They are excellent tools business owners or employers can use to retain and reward key employees.
- Companies can selectively choose plan participants.
- 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
- Non-qualified deferred compensation plans provide an additional source of retirement income for the key executive on top of any existing qualified retirement plans.
- The employee’s income deferral reduces their current income tax liability until retirement when they may be in a lower tax bracket.
- May provide per-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:
- 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.
- 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:
- A portion of the executive’s current income will be deferred thereby reducing current income taxes.
- When deferred benefits are paid to the key employee or his or her beneficiaries, the company can deduct the amount of the benefit payments.
- All benefits received by the key employee or his or her beneficiaries are taxable as ordinary income.
- 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.