As the U.S. economy continues to improve, so too has the job market, creating greater competition for talent. Today there are 0.9 unemployed persons per job opening1, contrast that with 1.9 prior to the latest recession and 6.6 per job opening in July of 2009. The labor market is tight. As such, businesses are confronting increasing challenges to attract, reward and/or retain key personnel. If a business were to lose a key employee to death, disability, or the competition there is just not readily available talent waiting to walk through the door tomorrow. By undertaking thoughtful planning today, business owners can implement value added benefit programs to reward and retain existing key executives and, when necessary, successfully compete for new talent.
As one might expect, with the economy growing, business owners and executives are seeking out additional ways to save for their futures.
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For many high-income earners, benefits provided by a qualified plan alone may not be adequate to provide the desired standard of living in retirement. In fact, due to contribution and other limits, many qualified plans discriminate against top executives. Fortunately, a qualified plan can be coupled with a non-qualified executive benefit plan (NQEB) to close the “retirement income gap”.
NQEB plans make sense for executives and shareholder/employees of a ‘C’ corporation, or for key employees who are not shareholders (or who hold a very small ownership interest in the employer) of a pass-through entity such as an ‘S’ corporation, partnership or limited liability company.
NQEB plans offer two primary sources of contributions. First, a true deferral plan is funded with income or bonuses the executive is already entitled to. Second, a Supplemental Executive Retirement Plan (SERP) is funded with employer contributions. In addition, a NQEB plan may be a hybrid plan combining employer and employee contributions. For the executive the NQEB plan acts like a qualified plan in that he or she defers or avoids current taxation of plan contributions and is taxed on benefits when paid. However, unlike a qualified plan, the employer does not receive a current deduction for amounts deferred but rather receives a deduction when the benefits are actually paid and taxed to the executive.
Amounts set aside are invested by the employer, typically in life insurance, mutual funds or a combination of both. Life insurance provides an attractive funding vehicle due to tax deferred growth of policy cash values, tax free access to those cash values to pay plan benefits and cost recovery of the employer’s costs and expenses via the tax-free death benefits.
Whether a true deferral plan or a SERP, a number of important observations can be made:
- The executive and the employer enter into a legally binding agreement where the employer agrees to pay the promised benefits. Most NQEB plans are designed as “defined contribution” plans where contributions are invested, and the actual benefit is not determined until the future based on investment performance of plan assets. “Defined benefit” plans, where the employer promises a specified benefit in the future, are rare.
- In order to avoid the many burdensome requirements of ERISA, all plan participants must be considered “top hat” employees, members of a “select group of highly compensated or management employees”. The plan can be completely discriminatory within this group.
- In order to defer recognition, NQEB plans are “informally funded” in that plan assets must be subject to the claims of employer creditors. If the employer goes bankrupt, plan participants become general creditors of the employer and are likely to only recover a fraction of the promised benefits. Rabbi trusts, while holding plan assets that remain subject to the employer’s creditors, ensure that plan assets are only used to fund the promised benefits and are not used for the operating needs of the employer.
A Closer Look at True Deferral Plans and SERPs
A “true deferral” plan allows executives to defer recognition of current income (including bonuses) until plan benefits are actually paid. Because the executive is deferring income which he or she is already entitled to, these plans are typically fully vested from day one.
These plans can be designed in several different ways, for example, as a Voluntary Salary Deferral, or as a Death Benefit Only plan. A Voluntary Salary Deferral design allows the executive to delay income today, and taxation until retirement when distributions are made. In this arrangement, it's possible to realize significant savings on income taxes alone with the expectation of realizing lower income tax rates while in retirement. The employer may or may not provide for a match on the contributions. A Death Benefit Only plan provides income to the executive’s beneficiaries, generally funded via a life insurance policy on the executive’s life.
With a Supplemental Executive Retirement Plan (SERP), the employer sets aside additional compensation for the executive with plan benefits payable in the future. The employer may add a vesting schedule so that the executive will forfeit plan benefits if he or she leaves prior to key dates.
A SERP arrangement typically states that the employer will pay out either a lump sum or a stream of income over a period of time in the future. The income received by the employee is taxable upon receipt and deductible to the business. A SERP could be either funded or unfunded.
A 401k Mirror plan is one type of hybrid plan combining a NQDC and SERP elements to allow the executive to defer current income which the business then matches. These contributions are not subject to the qualified plan limits, and matches can be made in the form of cash or company stock. To add a retention aspect to the plan, the employer can elect to include a vesting schedule on any matching contributions, to create a golden handcuff.
Accurate, secure and timely plan administration is essential to the implementation and successful operation of a NQEB plan. Generally, a third-party administrator (TPA) that specializes in NQEB plans will be needed to provide the proper accounting information for the employer’s records and tax returns, reporting and to track the performance of the underlying informal investments in meeting future benefit payments. The TPA fees are minimal and generally, are tax-deductible to the employer as an ordinary and necessary business expense.
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Highland Capital Brokerage has more than 20 years of experience with NQEB plans. Our experience endows us with the expertise to help you consider the full range of plan design and funding options for your NQEB plan. We serve as your partner and specialist from start to finish—designing the plan, weighing the funding options in the context of your needs, to plan implementation, and ongoing evaluation of the plan. Let us help you retain your key executives by filling in the retirement income gap they face. Finally, we work with some of the leading promoters and administrators of NQEB plans in the country and can assist you and your clients in designing and implementing NQEB plans.
Finally, a Bonus Plan is beneficial to business owners who want to fund personal life insurance for either death benefit protection or retirement accumulation needs. A Deferred Annuity may also be used for accumulation needs. A Bonus Plan is used when a business owner’s personal tax bracket is equal to or lower than the corporate rate. This typically happens in personal service corporations, high net profit corporations, or where the business owner has a low tax bracket due to large write-offs such as charitable donations. By taking an income tax deduction in the higher corporate tax bracket and taxing the owner in his or her lower personal bracket, tax leverage can be gained. Taking money out of the company in the form of a bonus also eliminates possible double taxation in the future, which occurs when money is left in the corporation.
Executive Bonus Plans represent a simple alternative to NQEB plans. The bonus funds a life insurance policy owned by the executive and is currently deductible by the employer and taxable to the executive.
This material does not constitute tax, legal, investment or accounting advice and is not intended for use by the taxpayer for the purposes of avoiding any IRS penalty. Comments on taxation are based on current tax law as of August 2018.
1 “Number of unemployed persons per job opening, seasonally adjusted” United States Department of Labor https://www.bls.gov/charts/job-openings-and-labor-turnover/unemp-per-job-opening.htm
Click below to access Highland's Non-Qualified Executive Benefits Brochure and Non-Qualified Deferred Compensation Highlights.