One option for providing retirement benefits is nonqualified plans. These plans have the following advantages:
- They can cover selected employees-not everyone need be included.
- They may provide different benefits for each covered employee.
- Vesting in plan assets may be customized. Under certain circumstances, plan assets may revert to the employer rather than be paid to the employee (e.g., if an employee violates agreement terms).
- No complicated government testing and reporting is required. Only a timely notification to the Department of Labor is required, avoiding submission to the IRS for prior approval and annual ERISA filings.
- High annual benefit maximums (only a reasonableness test is required) are permitted.
- There are no tax penalties for early retirement.
Executive bonus arrangements are simple and easy to administer, providing selected employees extra income from which financial products-including mutual funds, annuities, and life insurance, among others-may be purchased. At the same time, the employer receives a current income tax deduction. The employee may use any values accumulated in the purchased products for retirement income or for any other use the employee might choose.
Any products purchased are owned by your employees and are paid for either directly by your business or through cash bonuses to the employees. These payments or cash bonuses are included in the employees' current taxable income. The arrangement may also be structured to cover the income tax cost of the bonus to your employees.
Your business, however, has no recourse to any product values if the employee terminates employment, so executive bonus arrangements have limited value as "golden handcuffs" and may be more appropriate when tax deductibility or protection of product assets from the claims of your business creditors, rather than employer control, is most important.
In a split dollar arrangement, your business shares life insurance policy costs and benefits with selected employees. This type of arrangement is particularly suited for those situations where your business is looking to provide substantial additional benefits for selected employees accompanied by minimum current income tax to the employees and a high degree of employer control. This benefit permits the participating employees to accumulate policy cash values on an income tax-deferred basis while providing a significant, generally income tax-free survivor benefit to a personal beneficiary.
Normally, your business advances all or a portion of policy premiums in exchange for a share of the policy cash value and death benefits. The insured employee and the employee's personal beneficiary receive any balance of cash values or death benefits. An attorney-drafted split dollar agreement formalizes the specific terms and conditions of the arrangement. The agreement may characterize the arrangement as employer-owned, in which case the employee pays income tax on an "economic benefit" (imputed value of the death benefit), or as a loan to the employee to purchase employee-owned life insurance, in which case the employee pays income tax on imputed loan interest.
Under either scenario, since your business will normally control a significant portion, if not all, of the policy cash value, a split dollar plan functions effectively as a "golden handcuffs" tool while the agreement is in effect. Premium payments are not currently income tax deductible because of this retained employer interest. After retirement, the split dollar agreement may call for the employer to be reimbursed for its premium outlays, or for a bonus of those amounts to the employee and for the employee to acquire full control of the remaining cash values and death benefits.
Nonqualified deferred compensation plans are among the most effective tools used by employers to attract, retain, and reward executives and other key employees. These plans allow participants to defer income and taxes on that income until some agreed-upon future date, in amounts far higher than permitted by tax-qualified plans. Considerable flexibility is available, permitting you to tailor plans to meet your specific needs and business goals.
These plans may be informally funded over time using various financial products, or benefits may simply be paid from earnings of the company at the time the employee retires.
Using life insurance to informally fund the plans may provide your business with substantial key person death benefits and/or allow the payment of survivor benefits in the event of the participating executive's death. If desired, a plan can be designed to provide full cost recovery for the business.
Recovery of plan costs for your business is an important design feature in deferred compensation plans that is not available in tax-qualified retirement plans or in nonqualified executive bonus arrangements.
An attorney-drafted agreement formalizes the specific terms and conditions of the plan design.
There are two basic types of nonqualified deferred compensation plans:
Supplemental Executive Retirement Plans
In a Supplemental Executive Retirement Plan (SERP), your business agrees to make defined contributions or provide defined future benefits for the employee with no change in the employee's current base salary or bonus. So, to the employee, the SERP feels very similar to a noncontributory tax-qualified plan-such as a SEP or profit-sharing plan. However, because your employee has to satisfy specified conditions over time to receive these benefits, the plan has sometimes been referred to as "golden handcuffs."
Traditional Deferred Compensation Plans
In a traditional deferred compensation plan, the participating employee elects to defer receipt of a portion of base salary or bonus until some time in the future, such as retirement. Your business may agree to "match" a portion of the amounts the employee elects to defer. So, to your employee, this nonqualified plan seems much like making a pretax contribution to a 401(k) plan because it allows those participating employees to postpone paying federal income tax on the amounts deferred. Because of this similarity, it is sometimes called a 401(k) "mirror plan."
Many factors must be considered when deciding on which tax-qualified or nonqualified plan design or designs might be appropriate for your business. And no single design is going to provide you with every feature you'd like-some compromises are inevitable.
Fortunately, there are sophisticated decision tools available to help you organize information and make that decision. We offer a broad spectrum of qualified and nonqualified plans and products to support employer-sponsored executive benefit strategies. Be sure to discuss your options with your tax and legal advisors to make sure they are appropriate for your situation.
For employer-owned life insurance policies issued after August 17, 2006, IRC § 101(j) provides that death proceeds will be subject to income tax; however, where specific employee notice and consent requirements are met, and certain safe harbor exceptions apply, death proceeds can be received income tax-free. Life insurance proceeds are otherwise generally received income tax-free under IRC § 101(a).
Life Insurance is issued by The Prudential Insurance Company of America, Newark, NJ and its affiliates.