Planning for Retirement Needs

Copyright © 2007, The American College. All rights reserved. Used with permission.

Planning for Retirement Needs

NonqualifiedDeferred-Compensation

PlansChapter 15


Nonqualified vs Qualified Plans

• Less favorable tax treatment – Employer deduction when employee

taxed– Deferral of tax is allowed but

employer deduction deferred• More design flexibility

– Limit coverage to executives– Lower administrative costs


Tax Treatment• Employer’s deduction at time

employee has taxable income• Plan is usually designed to defer

income tax until benefit receipt• Earnings on assets set aside are

taxed as earnings to the employer


Tax Considerations• Substantial risk of forfeiture (no tax)• If no risk of forfeiture then tax still

deferred unless– Economic benefit doctrine– Constructive receipt (409A)


Substantial Risk of Forfeiture

• Taxes deferred if substantial risk of forfeiture • “A substantial risk of forfeiture is a significant

limitation or duty that requires the fulfillment of a meaningful effort by the executive, and there must be a definite possibility that the event that will cause the forfeiture could occur.”– A traditional vesting provision is clearly a substantial risk

of forfeiture. – -Requiring that an executive continue to provide

consulting services to a company after retirement may or may not be a substantial risk of forfeiture, depending upon the specific facts and circumstances.


Economic Benefit Doctrine• Participant has current income if

arrangement provides current economic benefit even if no current right to receive benefit

• Irrevocable trust with nonforfeitable benefits results in current income tax

• Plan assets typically stay in the name of the employer

• Rabbi trust is allowed since assets can be accessed by claims of the sponsor’s creditors


Constructive Receipt 409A• Failure to satisfy distribution, acceleration of

distribution, and deferral election rules results in current income tax and an additional 20 percent penalty tax.

• Distribution only upon stated events – Separation from service – Disability – Death of the employee– A time specified under the plan.– A change in ownership or control.– Occurrence of an unforeseeable emergency.


409A • Plan may not allow acceleration of distributions

except– Payments for domestic relations order– A de minimus cashout of up to $10,000 – Payments for FICA taxes

• Employees’ elections to defer – Election to defer must generally be made in preceding year– Rules require time and form of distributions determined at

initial deferral– Plan can specify form and timing or give participants a choice– Exception allows a participant to delay existing benefit as

long as election is made 12 months before


FICA Taxes • FICA taxes on the later of

– Date services are performed or – No longer a substantial risk of forfeiture

• Issues – Different timing than income tax rules– Nonduplication rule—tax only paid once


Plan Design--Objectives• Golden handshakes—induce

retirement• Golden handcuffs—stay with

company• Golden parachutes—soften landing

upon takeover • Incentive pay—bonuses for

meeting goals


Types of Deferred Compensation

• Salary reduction– Similar to 401(k) salary deferrals– To defer taxes – Systematic savings

• SERP– DB or DC– Additional benefit– Offset (reduce by qualified-plan

benefits)


Design ConsiderationsFrom the Employer’s

Perspective

• Forfeiture (not for salary deferrals)• Continued consulting• Retaining executives• Do-not-compete clause


Design ConsiderationsFrom the Employee’s

Perspective

• Takeover trigger (golden parachute)• Immediate vesting• Hardship withdrawals• Binding arbitration for disputes


Other Design Considerations

• Benefit structure• Eligibility• Disability• Retirement age• Death benefits


Funding• Impact of “funding”• Informal funding• Rabbi trusts

– Defer taxation– Meet security concerns

• Secular trusts– Irrevocable trust– Current taxation

• Surety bonds


Rabbi Trust• Assets available to creditors• Irrevocable or springing irrevocability• No insolvency triggers• Notify trustee of pending financial

problems that trigger suspension of benefits


Life Insurance• Tax-free inside buildup• Protects against premature death• Life insurance proceeds tax free• Funding flexibility—use cash value or

keep in force and receive death benefits• Company ownership eliminates tax

problems


Installation • Corporate resolution• Plan document• Rabbi trust• ERISA notice sent to DOL


ERISA Considerations• Generally satisfy “top-hat” exemption

– “Plan must be unfunded and maintained by an employer, primarily for the purpose of providing deferred compensation for a select group of management and/or highly compensated employees.”


457 Plans• Nonqualified plan sponsored by tax-exempt or

governmental entities subject to Code Sec. 457• 457(b)

– Salary deferrals can’t exceed $15,500 (in 2007)– Catchup elections allowed

• 457(f)– Conforming salary deferrals– Tax when no substantial risk of forfeiture


Executive Bonus Life Insurance• Also called Sec. 162 plans

• No coverage requirements• Employee is the policyowner, insured and

chooses the beneficiary• Employer simply pays a bonus equal to the

premium• Employee has taxable income and

employer gets a deduction• Double bonus—employer pays premium

and taxes on payment


Double Bonus Example• Step 1: State target premium

$10,000.00• Step 2: Specify the applicable tax

rate .40• Step 3: Subtract step 2 from 1.00 = .60• Step 4: Divide the step 1 amount by the

step 3 amount to find the amount of both bonuses: $16,666.67


Quick Quiz—Match the following:

1. xxIncentive stock options

2. Golden parachutes3. Golden handshakes4. SERP5. Surety bonds

A. Supplemental plan to replace employment income at retirement

B. Options to acquire stock with no tax consequences at the time of stock acquisition

C. Benefit package at retirement to induce early retirement

D. Payments to an executive upon change of ownership

E. Agreement by a third party to guarantee benefit payments


Quick Quiz—Match the following:

6. “Funded” plan 7. Golden handcuffs 8. Rabbi trust 9. Salary reduction

plan10. Constructive receipt

F. Funding instrument in which assets are subject to employer’s creditor

G. Plan in which executives agree to defer current compensation

H. Taxation at the time contributions become vested

I. Opportunity to receive compensation regardless of actual receipt

J. Discouraging termination of employment by requiring additional service to vest in plan benefits


True/False Questions• Salary deferral type nonqualified plans will

typically have a deferred vesting schedule. • Code Sec. 409A allows distributions at the time of

a participant’s disability.• Nonqualified plans may have the objective of

providing benefits in excess of the qualified plan contribution or benefit limits.

• A nonqualified plan will be considered funded if assets owned by the corporation are earmarked for funding the required payments.


True/False Questions• To avoid tax problems a surety bond used to

secure funding in a nonqualified plan must be purchased by the executive.

• A nonqualified plan that is designed to make substantial benefit payments if there is a change in ownership is referred to as a golden handcuffs provision.

• In a nonqualified plan, income taxes can be deferred if the benefit is subject to a substantial risk of forfeiture even if the plan confers a current economic benefit.

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Planning for Retirement Needs