Podcast Center
Video Center
Webcasts
Resource Center
Events
June 14, 2005 at 08:00 PM
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).
