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.