The Plan and Its Funding
Taking Flight into the World of Non-Qualified Retirement Planning
As a business owner, have you been concerned about either “taking care” of your best employees and/or losing key talent to a competitor? Further, are you interested in providing a way to recruit top talent to your organization? Employees, do you wish you could put more money away for retirement in addition to your 401(k) and other qualified plan contributions? If so, it may be time for you to take flight into the world of non-qualified retirement planning.
Before takeoff, there are two equally important considerations or “check-offs” to consider. The first consideration is plan choice and structure. The selection of the right plan (and structure) will likely result in a successful expedition defined by the goals and objectives you set. A wrong choice may result in a plan that is not efficient and does not achieve the desired effect for engaging in the plan in the first place. The second “check-off” is how to fund the plan. While a non-qualified plan may be left unfunded, life insurance is often the preferred funding vehicle of choice. It will be important for you to keep these two “check-offs” in mind not only as you begin flight but throughout the journey, or life of the plan chosen.
RULES OF ENGAGEMENT
There are a number of rules that must be navigated before “plan takeoff.” The most important issues to consider include who may participate and federal tax implications.
- Who may be ticketed to fly? – Non-qualified retirement planning is not for everyone. Generally, there are two different ways an individual may “earn a ticket” to participate in a non-qualified retirement plan. The first way to qualify is income. Generally speaking, if an individual earns more than the Social Security wage base ($110,100 in 2012), he/she is eligible to participate. This type of qualification is often referred to as a “top hat” qualifier. The second way to qualify is job title and responsibilities. An individual who does not qualify as a “top hat” qualifier may be eligible if he/she is considered a manager or distinct from the rank and file of the organization. Including a participant who does not qualify may make the plan subject to ERISA (the Employee Retirement Income Security Act), negatively impacting tax treatment.
- Rules of the air: Evolution of tax implications since Enron – In 2004, Congress enacted strict rules regarding the funding and distribution of funds from deferred compensation plans. These rules, codified as Internal Revenue Code Section 409A, were passed in response to the bankruptcy of Enron. One of the major reasons Enron faced bankruptcy was due to the acceleration of non-qualified retirement benefits to company executives. Income deferrals to non-qualified plans must be timed correctly and distributions must be made upon the occurrence of a “triggering event” (death, disability, separation of service, or change in control of the employer).
THREE IS A CHARM: PLAN OPTIONS
Following are three non-qualified retirement planning aircrafts of choice. Each type of plan will take off (deferral choice and funding) and land (distributions and plan recapture) differently.
- Executive Bonus Plan(s) – An executive bonus plan is a non-qualified retirement plan that is funded by a cash bonus. The major advantage of adopting an executive bonus plan is simplicity. Executive bonus plans are not subject to the “Enron rules” because a deferral is not made to fund the plan. The employer may take a deduction pursuant to Internal Revenue Code Section 162 for the amount contributed (or bonused) to the plan participant. The executive will have to include the salary increase in his or her taxable income, but after paying taxes, the remaining bonus will be available to fund premium payments for a life insurance policy.
Even though the plan participant is taxed on the bonus granted, a restriction may be placed on the plan restricting the employees’ access to plan proceeds for a reasonable period of time. The employer retains the power to release the restriction and give the employee access to policy cash values, thus encouraging the employee to remain with the company and creating “golden handcuffs.” If the employee fulfills the agreement, he or she will eventually have access to the policy cash values, as well as the ability to provide his or her beneficiaries with an income tax-free death benefit. The “reasonable period of time” standard is usually defined by state statute or case law in the jurisdiction where the plan is created.
- “Traditional” Deferred Compensation – A “traditional” deferred compensation plan is a non-qualified retirement plan that is funded by either the plan participant who makes a deferral of current income or a combination of a deferral by the plan participant and a matching contribution by an employer/business owner. Business owners of “C” Corporations may also defer compensation in a “traditional” plan. This strategy may provide a means for a “C” Corporation owner to transition or “exit” their company through a third party sale or key employee transfer.
The plan participant is not taxed on the plan proceeds until he/she is eligible for a distribution pursuant to the aforementioned triggering events under the “Enron rules.” Investment performance may be measured by company growth, a crediting percentage, or other formula. Like executive bonus plans, “traditional” deferred compensation plans may impose a vesting schedule on plan participants, which is subject to a “reasonable period of time” standard.
In preparing for takeoff, the company has a number of options that are available to provide funding for the plan. The company can fulfill its obligations to its executives by establishing a fixed rate of return that will be paid for out of general operating assets when the payout is due. The company may tie the executive’s savings to particular mutual funds that are selected and may also use deferred annuities as a funding mechanism. Cash value life insurance is also a popular and efficient option, which if structured properly can provide the employer with access to cash value within the policy to fund its obligation to the employee. In addition, the employer is entitled to receive any remaining death benefit, which can serve to fund future obligations.
- Supplemental Executive Retirement Plan(s) – A Supplemental Executive Retirement Plan (SERP) is a non-qualified retirement plan that is usually funded by the employer/small business with the option of a plan participant match. Like “traditional” plans, SERPs are subject to the federal non-qualified retirement plan rules under IRC 409A. SERP plans often resemble defined benefit plans as the plan participant will often receive a benefit based upon a percentage of current income or formula.
To ensure a smooth take-off and landing, companies may opt to fund their SERP plans by utilizing current assets, a separate sinking fund or through the use of corporate owned life insurance (COLI) insuring key executives they wish to compensate. The benefits to COLI are extensive but the key advantage is that the business is designated as the beneficiary of the life insurance policies. Upon the death of a key executive, the company will be reimbursed for some or even possibly all of the costs of the insurance plan, which would include the actual benefits paid to the employee along with the cost of insurance.
- Additional Protection for Employers/Business Owners – Business owners implementing a non-qualified retirement plan should consider adding some additional “flight protection.” Such protection includes the execution of an employment agreement by the plan participant. The purpose of an employment agreement is to acknowledge not only the existence of the plan but also define the rights and responsibilities of both the plan participant and plan sponsor. Business owners should also consider having their key talent execute a covenant not to compete, a confidentiality agreement, and a trade secret agreement (if applicable). All such “flight protection” issues are subject to federal and state law.
Non-qualified retirement plans provide a stealth way to recruit, retain and reward key talent. As you taxi to the runaway, remember to “check off” on your plan structure and how you intend to fund the plan you ultimately choose. After your “check off” is complete, you are cleared for takeoff. If implemented and managed correctly, this will be a flight that your business and your key talent will mutually enjoy.
This article originally appeared in the Summer 2012 issue of Wealth magazine.
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