Nonqualified deferred compensation arrangements offer many solutions

Highly compensated executives and business owners have a unique problem in funding their own retirement. Tax-favored qualified plans restrict highly compensated individuals with limits on the amounts that can be deferred or contributed into these plans. Their contributions to Social Security also are capped.

These factors restrict their ability to accumulate money for retirement on a tax-favored basis. These factors also result in the highly compensated individuals being responsible for funding a greater percentage of their retirement income through personal savings.

Yet, the savings rate among the affluent falls significantly short of what is needed for them to maintain their present standard of living in retirement.

Nonqualified Deferred Compensation Arrangements

An NQDC arrangement may be the solution to these restrictions. If properly structured, the executive or business owner can avoid income taxation until the deferred amounts are actually or constructively received. (Note that these amounts are not tax-deductible by the business until paid out.)

There are two primary types of deferred compensation plans: salary reduction plans, which allow the individual to elect to defer some regular compensation, and supplemental executive retirement plans. Also known as salary continuation plans, SERPs provide a retirement income for the executive or business owner without reducing current compensation.

Benefits to be paid in retirement are established in a written contract. The benefits must be subject to a “substantial risk of forfeiture,” i.e., leaving earned compensation with the business in a salary deferral plan or staying with the company for a period of time in a salary continuation plan.

Working With the Business Owner to Fund the Arrangement

Life insurance may be used to fund these plans informally, thereby providing significant pre- and post-retirement death benefits while accumulating funds to provide retirement income. The business owns the life insurance and the business is the named beneficiary.

Cash values are an asset of the corporation and the business receives the death benefits income tax-free. Note, however, that if the business is subject to the Alternative Minimum Tax, the life insurance may be taxable at a 15% rate (20% tax on 75% of adjusted current earnings).

The individual has no personal ownership interest in the life insurance as the salary benefits must be an “unsecured promise” by the business.

Business owners are looking for a sophisticated financial vehicle to help them protect their assets on the downside and allow them to participate on the upside–a plan that offers death benefit guarantees, opportunities to access the stock market and tax benefits.

One product that offers all these features is variable universal life insurance. VUL products have been improved significantly in recent years to allow funding to a fixed account that provides a low-cost, defined death benefit, and that can be guaranteed regardless of market performance. The policies also offer investment performance, diversification and flexibility through a variety of subaccounts.

This mix of capabilities makes VUL ideal for meeting the needs of business owners seeking funding for supplemental retirement income for themselves and their key executives. VUL provides investment performance, diversification, flexibility and–with appropriate funding to the fixed account in the new products–a death benefit that can be guaranteed regardless of market performance.

Business planning situations almost always allow life insurance policies owned by the business to be used to solve multiple problems. Life insurance can fund business owner and key employee retirement arrangements, business succession plans, key employee insurance and other business needs.

How a Salary Reduction Plan Works

o The business owner or key employee elects to defer some percentage of his or her salary or bonus. Income tax is not due on that money until it is received.

o The business enters into a written agreement setting the terms for when the deferral is to be paid (usually retirement).

o The business establishes a sinking fund or purchases a life insurance policy on the individual to cover the liability of the future payments.

o At retirement, the business pays the deferred salary as specified in the agreement. The business deducts the payment as salary paid; the individual pays income tax on the salary paid, including FICA and FUTA.

How a Salary Continuation Plan Works

o The business promises to pay an individual a set retirement income contingent on the condition of continued employment for a period of years. The business does not get a deduction; the individual does not pay income tax on that money until it is received.

o The business and the individual enter into a written agreement setting the terms of the unsecured promise with a substantial risk of forfeiture.

o The business establishes a sinking fund or purchases a life insurance policy on the individual to cover the liability of the future payments.

o At retirement, the business pays the continued salary as specified in the agreement. The business deducts the payment as salary paid; the individual pays income tax on the salary paid, including FICA and FUTA.

If the executive is not comfortable with the future of the business…

NQDC is only an attractive benefit if the executive has confidence in the continuation of the business. A portable benefit that can be used as an “enticement” to handcuff executives is the Section 162 or executive bonus plan.

In this arrangement, the owner pays premiums on life insurance policies for the benefit of key employees who own the policies. The employee pays income tax on the bonus. As long as the bonus represents “reasonable compensation” as defined by IRC Section 162, the business deducts the premiums paid. As both policy owner and the insured, the key employee names the beneficiary.

Benefits for the Executive

o Compensation for life insurance with the out-of-pocket cost limited to tax on bonus (cost can be zero net cost to the executive with a bonus of the tax due–a “double bonus”);

o Builds tax-deferred funds for retirement;

o Additional family protection on early death; and,

o The executive has a portable benefit that he or she owns.

Many projections for needed savings for retirement will fall short of individual needs. Due to reductions in Social Security benefits and cutbacks in employer-sponsored plan benefits, more individual savings will be required to fund the retirement your clients may have planned. Now is a good time to review your clients’ retirement needs.

Donna Nearhood, J.D., CLU, ChFC, is an affluent markets consultant at Columbus Life Insurance Co., Cincinnati, Ohio. You can e-mail her at Donna.Nearhood@ColumbusLife.com.

The primary types of deferred comp plans are salary reduction and salary continuation plans

Business planning situations almost always allow life insurance policies owned by the business to be used to solve multiple problems