Utilizing Nonqualified Retirement Plans As Fringe Benefits

Joseph Milano, CLU, CHFC, CLTC, is a Managing Partner at New South Wealth Management.

Employee turnover is expensive, and losing key personnel can have devastating effects on a company. Organizations are often coming up with new ways to recruit talented people and offer their best workers incentives to remain instead of seeking positions elsewhere. Nonqualified retirement plans can sometimes be that “extra something” that rewards and retains the best of their workforce.

Retirement Plans For Employees

According to one survey, 50% of U.S. companies offer employees a retirement plan as part of their benefits package. The statistic is heavily skewed based on company size, i.e., about one-third of small companies (20 or fewer employees) offer retirement benefits compared to 98% of large companies (5,000 or more employees). Data from the Bureau of Labor and Statistics reports over half of survey respondents say having access to a retirement plan at work.

Most of these plans are considered qualified plans, i.e., they are federally approved after meeting IRS requirements. Such plans fall under the Employee Retirement Income Security Act of 1974 (ERISA), which was enacted to protect the retirement funds of U.S. employees within private industry. There is much reporting required, and employers are obligated to stay apprised of any changes in retirement plan laws and regulations. However, qualified plans allow employers an attractive tax break on the contributions made on behalf of employees.

Some common qualified plans are as follows.

• 401(k) plan.

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• 403(b) plan.

• Pension plan.

• Profit-sharing plans.

• Employee stock ownership plans (ESOP).

• Money purchase plans.

Why Consider Executing A Nonqualified Plan?

While many workers have come to expect a retirement plan as part of an organization’s benefits package, it is not enough for some high-earning employees. ERISA guidelines provide that contributions or benefits do not discriminate in favor of highly compensated employees. All employees are to receive equal benefits from the retirement plans, so the IRS set regulations to ensure against highly compensated employees contributing much more to tax-free plans and lowering their tax liability in a way that is out of reach for other workers. That means that highly compensated employees are limited in the size of contributions they can make.

This is where a nonqualified plan could come in. Such plans do not come with the tax advantages that qualified plans do, but they are free from IRS regulations and ERISA guidelines. Companies can come up with innovative ways to provide additional retirement plans to compensate high earners. Two popular nonqualified plans are an Executive Bonus Plan and Supplemental Executive Retirement Plan (SERP).

Executive Bonus Plan

In this plan, an employee owns a permanent life insurance policy. They select a beneficiary and have access to the cash value. The employer “bonuses” money to cover the costs of premiums. Sometimes an employer will “double bonus” to cover the income taxes created by the premium payment compensation. This plan is very straightforward, making it easy to administer. A written agreement is drawn up to ensure both sides understand how the plan will be executed, e.g., whether the premium payments will be paid directly or indirectly.

Occasionally, companies will want to retain control over the cash value of the policy. This would mean restricting access to the cash value rights until a stated retirement date or when a length-of-service requirement is reached. The reasons for this may be to help prevent the key employee from starting a competing business or simply to add an incentive for the employee to stay with the company. A separate agreement, called a custodial executive bonus arrangement, is executed to the restriction.

There are several advantages to employing this plan.

• Easy to administer.

• Limited reporting requirements.

• Selectivity in choosing participants (not ERISA regulated).

• Premiums paid are tax-deductible.

• Executive access to the policy’s cash value.

• Usable with annuity or disability insurance instead of life insurance.

Supplemental Executive Retirement Plan (SERP)

Since high earners are restricted by the amount they can contribute to a qualified retirement plan, they may look for ways to enhance their income when they stop working. A SERP may be the answer as it is a written agreement to pay an employee a steady stream of retirement income or a lump sum at retirement. Since it is outside ERISA regulations, employers can be selective in whom is offered such an arrangement while enjoying flexibility in its execution. Companies normally purchase a life insurance plan for the employee to fund the plan. When the executive retires, funds are paid out from the company cash flow and/or the cash value of the policy. When the executive dies, the company can then recoup the costs it paid out.

There are several advantages to employing this plan.

• Fairly easy to administer.

• Limited reporting requirements.

• Selectivity in choosing participants (not ERISA regulated).

• No contribution limits.

• Company-deductible retirement payments.

• Employees are taxed only when retirement benefits are received.

• Employer owns the policy and controls its cash value.

• Recoverable costs via the policy death benefit.

• Tax-free life insurance proceeds paid to the company.

Since this is a supplemental retirement plan, there is an inherent “golden handcuffs” feature to its structure. Employers often offer a fringe benefit to high-earning key employees to keep them with the company, as the executive knows that they cannot collect on the plan until a certain date.

Other Nonqualified Retirement Plans

Some other plans to consider are the deferred savings plan, split-dollar arrangement and group carve-out plan. Nonqualified plans never qualify for the same tax treatment as qualified plans do. However, correctly structured plans enjoy tax advantages. Tax professionals and financial advisors should always be consulted before proceeding with any arrangement discussed here. This is particularly important if the company owner is participating in one of these plans. Consulting with experts is the first step in structuring that win/win plan to benefit both employer and employee.

The information provided here is not investment, tax or financial advice. You should consult with a licensed professional for advice concerning your specific situation.


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