Historically for nonqualified retirement plans the tax and pension rules have been relatively few and easy to meet, compared with the extensive statutory constraints imposed upon qualified retirement plans.
The landscape has changed recently with the enactment of Internal Revenue Code Section 409A, and now most nonqualified plans must meet specific requirements related to such things as timing of deferral, events of payout, acceleration of benefits, re-deferrals, funding and governmental reporting. For a practitioner who is engaged to assist in the design of a tax-exempt employer, however, there has been, since 1987, a statutory overlay in the form of Internal Revenue Code Section 457.
Taxation of ineligible Section 457 plans
Section 457 creates two forms of nonqualified deferred compensation plans by setting forth requirements for a plan to be “eligible.” These requirements include limitations on amounts that may be deferred annually, which are similar in amount to limitations imposed on 401(k) deferrals and required distribution structures that parallel the rules applicable to qualified accounts. Amounts deferred other than through an eligible plan will not enjoy deferral of taxation to the executive unless those amounts remain subject to a substantial risk of forfeiture.
This generally proves problematical for voluntary deferral arrangements but may be of value to tax-exempt employers wishing to create “golden handcuffs” to retain valued executives. Thus, the employer may create an “ineligible” plan, one wherein the full value of the promised benefits are non-vested, i.e., subject to a substantial risk of forfeiture, until the occurrence of one or more events, such as death, disability or retirement.
(Note that Section 409A, which limits permissible payout events, applies only to ineligible Section 457 plans. Under Section 409A, amounts are not considered deferred until the service provider has a “legally binding right” to the compensation. If Section 409A is not complied with, deferred amounts are taxable when they are not subject to a risk of forfeiture.)
Because of the specific requirements that plan values remain subject to a risk of forfeiture, post-retirement distribution planning may become problematical. Irrespective of the chosen payout scheme, the full value of the plan, if vested at retirement, will be includable in the retiree executive’s income.
Installments as received will, in part, constitute tax-free recovery of plan values already taxed. An employer may attempt to defer vesting, post-retirement, by imposing continuing duties on the executive. This raises the issue as to whether the risk of forfeiture continues to be “substantial,” which under applicable tax regulations is a facts and circumstances test.
Since the enactment of Section 409A, it may be risky to create a plan that meets the separation-from-service payout definition while continuing to defer vesting by imposing service-related duties intended to be “substantial.” As a result a conservative plan structure might entail, since the executive will be taxed immediately in any event, the distribution of a lump sum at retirement.
Employer-owned life insurance is often the preferred vehicle for informal funding of nonqualified plans. For tax-paying employers, life insurance is valued for its income-tax characteristics, i.e., tax-deferral on cash value buildup, distributions on a return-of-investment-first basis (if a non-modified endowment contract) and ultimate tax-free receipt of death benefits.
For the tax-exempt employer, these tax benefits are generally of no relevance so long as the policy is employer-owned. Where there is no independent basis for holding life insurance for its death protection element, the tax-exempt employer may be reluctant to expend funds for a product which it, rightly or wrongly, perceives to carry higher cost and expense structures than other available funding media.
Why fund with life insurance?
In some circumstances, particularly cases involving smaller tax-exempt employers, life insurance may provide benefits that other funding media cannot readily duplicate. These include:
–Enhanced survivor benefits