In today’s business market, it’s more important than ever to recruit and retain top executive talent to ensure the growth and long-term success of a business. One way to do this is by offering benefits that address a key concern of management and highly compensated employees: retirement planning.
Employers turn to nonqualified deferred compensation plans as an executive benefit because the Internal Revenue Code (“IRC”) and the Employee Retirement Income Security Act of 1974 (“ERISA”) place restrictions on qualified plans. For example, qualified plans must meet stringent requirements for nondiscrimination, participation, vesting and reporting.
Additionally, such plans often do not provide equitable treatment for highly compensated employees because statutory limits cap the amount that can be contributed to a plan, creating “reverse discrimination.” Thus, nonqualified plans can be an attractive alternative to rewarding valued executives who wish to create additional income for retirement.
Overcoming Retirement Savings Discrimination
Most executives and key employees understand the value of tax-deferred savings for retirement. And for most, 401(k) and other employer-sponsored qualified plans represent the only option for tax-deferral. Unfortunately, there are limits on the amount that can be contributed to a 401(k) and other qualified plans. As of 2006, the maximum an individual can contribute to a qualified plan is $15,000.
This contribution limit more greatly impacts highly-compensated executives than it does average workers. This is because it limits the participation of highly-compensated executives to a significantly smaller ratio of retirement savings than is allowed for average workers. For example, an employee who earns $50,000 per year would be able to contribute up to 30% of pre-tax earnings to a qualified 401(k) plan, whereas an executive earning $200,000 per year can contribute only 7.5% of pre-tax earnings (See chart ‘A’.)
When it comes to retirement plans, highly paid executives are the victims of reverse-discrimination. The more they earn, the smaller a portion of their earnings they can contribute to a qualified retirement plan. Fortunately, a 401(k) look-alike plan allows executives to overcome this discrimination by permitting tax-deferred contributions to a nonqualified retirement plan.
Nonqualified 401(k) Look-Alike Plan
This employer-sponsored plan allows executives to make voluntary deferrals on a pre-tax basis and it permits employer-matching on all or a portion of contributions. The plan lets executives:
? Reduce current taxable income.
? Establish a savings fund for retirement.
? Enable retirement savings to grow on a tax-deferred basis.
? Tailor the plan investments to meet personal goals.
Steps to Implement the Plan While the Executive Is Employed
1. The employer and the executive enter into a contractual arrangement to defer future compensation. The terms of the plan are documented.
2.Each calendar year, the executive elects to defer a portion of current compensation prior to the period of service in which the compensation will be earned. The employer may set limits on the deferral amount.
3. The employer matches all or a portion of the executive’s deferral according to the agreed upon formula.
4. Deferrals, matching employer contributions and earnings, are periodically credited to a bookkeeping account in the executive’s name.
5. The employer purchases a key person insurance policy on the executive’s life. The policy serves as an informal funding vehicle for the promised benefit.
? The employer provides written disclosure to the executive of its intent to purchase a policy, the amount of death benefit to be purchased, and of the employer’s intent to retain ownership of the policy even after the executive terminates employment.
? The employer obtains written consent from the executive to purchase the key person life insurance policy.
When the Executive Retires
6.The employer pays the promised benefit. The payment is deductible to the employer (assuming compensation is reasonable). The retirement benefit is taxable compensation to the executive.
7. With proper design, the benefits can be paid using income-tax-free withdrawals to basis and loans from the life insurance policy owned by the employer. (This assumes the policy is not a modified endowment contract (MEC) and the policy does not lapse.) Alternatively, the employer can pay the liability from current earnings and recover the cost of the plan upon receipt of the death benefit.
If the Executive Dies Prior to Retirement
8. The policy pays an income-tax-free death benefit to the employer (although the benefit may be subject to the corporate alternative minimum tax).
9. The employer pays benefits owed to the executive’s designated beneficiaries. This payment is deductible to the employer and is taxed as ordinary income (as income in respect of a decedent or IRD) to the beneficiaries (see chart ‘B’).
Potential Disadvantages of 401(k) Look-Alike Plans:
? Subject to IRC ? 409A rules.
? Employer must comply with COLI “Best Practices” legislation.
? Funding asset is subject to claims of employer’s creditors.
? Timing of payments must be fixed when the plan is adopted.
? Death benefit paid to the executive’s survivors is taxable as ordinary income.
Cost Recovery and COLI “Best Practices”
401(k) look-alike plans can be especially attractive if the business can recover the cost of funding the arrangement. Life insurance offers an effective means to recover plan costs on an income tax-free basis. To receive life insurance proceeds exempt of income taxes, however, an employer must comply with the corporate owned life insurance (“COLI”) provisions of the recently passed Pension Protection Act of 2006. Under these provisions, life insurance proceeds received by an employer will continue to be income tax-free so long as the business meets both of the following requirements:
1. The insured was an employee of the corporation within 12 months of death. Or, at the time the policy was issued, the employee was either a director of the corporation, a highly-compensated employee under IRC ? 414(q), or was among the highest-paid 35% of the corporation’s employees; and
2. The employer meets the following notice and consent requirements: (i) The employee is given notice that the company intends to insure his or her life and to the maximum amount of death benefit the employer will apply for; (ii) the employee is informed in writing that the company will be a beneficiary of the policy death benefits; and (iii), the employee consents in writing both to being insured and to coverage continuing beyond employment.
401(k) look-alike plans offer highly-compensated executives an opportunity to defer income for retirement beyond the contribution limits imposed on qualified retirement plans. These plans may be used by employers to recruit, retain, and reward the talent needed to keep the business successful. And when informally funded with life insurance, the plans can accumulate funds on a tax-deferred basis and may be designed to provide cost recovery for the employer.