As American business enters the 21st century, old methods are being replaced with the new. Nowhere is this more evident than in key employee and business owner compensation, and specifically in deferred compensation planning.
A deferred compensation plan (DC plan) allows an individual to defer a portion of current income, and the taxes due on it, until a future point in time — usually retirement.
Because it is a non-qualified plan, employers may select whomever they want to participate from their executive or management team. There are no contribution limits and no significant filing or reporting requirements.
On the negative side, contributions are not tax deductible until benefits are paid to participants and benefits may be taxable to participants when they have the right to receive them — not necessarily when they are actually paid.
DC plans come in many shapes and sizes. Choosing the right plan depends on a company’s goals and the selected participants’ goals. Let’s consider a few structures:
Reduction or continuation?
DC plans generally fall into one of two categories — “salary reduction” or “salary continuation.” Under a salary reduction plan, participants agree to defer a portion of their current salary (or bonus) to a future point, allowing them to postpone paying taxes on it until they are likely to be in a lower tax bracket.
Under a salary continuation plan, the employer agrees to provide participants with additional compensation above their regular salary, but defers payment until a later date.
Contribution or benefit?
When an employer chooses a salary continuation plan, another consideration is whether it should be a defined contribution plan, where the amount contributed on behalf of participants is established under the plan agreement, or a defined benefit plan, which specifies the amount each participant will collect at retirement.
Under a defined contribution plan, retirement benefits could vary depending upon the performance of the underlying funding vehicle(s). Under a defined benefit plan, the amount payable at retirement is guaranteed, but annual contributions may vary — making it difficult for an employer to work plan contributions into its annual budget.
Contributions to certain DC plans can be made by both the employer and participants. In such cases, participant contributions are generally matched by the employer in much the same way as a traditional 401(k). These kinds of DC plans are often referred to as 401(k) overlay or 401(k) mirror plans, and can be used in conjunction with, or in place of, a traditional 401(k) plan. When used in conjunction with a 401(k), it can help equalize retirement benefits for highly compensated key employees who, because of government regulated funding limitations, would otherwise receive a lower percentage of wages at retirement than lower-paid counterparts.
Once the determination has been made as to which type of DC plan is best, the big question becomes how to fund it.
Some employers choose to pay the agreed upon benefits out of company cash flow and hope that it will be adequate when benefits come due. Others use securities such as stocks, bonds and other investment options to finance their plan.
Unfortunately, unforeseeable market fluctuations can leave these types of plans underfunded when benefit payments are scheduled to begin. Another disadvantage is that investment gains are taxable when realized, which can burden an employer’s bottom line.
To address that, many employers turn to company-owned life insurance (COLI) to fund their DC plans. Under COLI, the employer buys a cash value life insurance policy on each participant, and is the owner, premium payer and beneficiary on each policy. Salary deferrals and/or company contributions are used to pay the policy premiums. Policy cash values grow income tax-deferred and, at retirement, can be accessed via loans or withdrawals to pay plan benefits. Withdrawals and outstanding loans will reduce the policy’s cash value and death benefit.
If a participant dies prior to retirement, the plan can provide for a death benefit to be paid to a beneficiary. And policy riders can be added to provide disability benefits if disability is a benefit trigger.
Using life insurance as funding can also allow an employer to recover the plan cost through the receipt of death proceeds, and contractually guaranteed cash values can ensure that the funds required to pay benefits will be there when needed.
Under a COLI arrangement, the employer can change who is insured; it can pay benefits from either policy death benefits or policy cash values; premium, interest and expense guarantees allow the employer to develop a long-term financing plan; and buying as a group often allows for favorable underwriting considerations.
How do DC plans work?
There are four steps to establishing a DC plan. First choose the employees who will be included in the plan, the benefits which will be paid out and the triggers that will initiate benefits payment. Step two is deciding where the salary deferrals will come from. Step three is the funding vehicle — and if life insurance, the purchase of a cash value life insurance policy on each participant. Step four is the payment of benefits following a trigger event.
DC plan benefit payments become a tax deduction to the employer and are taxed as ordinary income to the participant or beneficiary. If properly structured, at the participant’s death, a portion of the life insurance proceeds can be used to reimburse the employer for premiums and/or benefits paid. It’s that simple.
If you’re looking for ways to reduce current income taxes and supplement future retirement income — or to attract, motivate and retain high-quality employees — a DC plan may be what you need. JN
Doug Hall is a partner at 1847Financial in