Chartered Retirement Planning CounselorSM
Professional Designation Program
Module 5
Individual Deferred
Compensation
©2013, College for Financial Planning, all rights reserved.
Learning Objectives
5–1: Describe characteristics of nonqualified deferred
compensation plans.
5–2: Describe different types of nonqualified plans and the tax
implications of each for employer and employee.
5–3: Identify similarities and dissimilarities between various
types of nonqualified deferred compensation plans.
5–4: Analyze a situation to determine whether a nonqualified
plan would be appropriate.
5–5: Describe alternative methods available for funding
nonqualified plans and the advantages and disadvantages
of each method for employer and employee.
5–6: Identify similarities and dissimilarities between different
approaches for securing the employer’s promise to pay
deferred compensation.
5-2
Questions to Get Us Warmed Up
5-3
Learning Objectives
5–1: Describe characteristics of nonqualified deferred
compensation plans.
5–2: Describe different types of nonqualified plans and the tax
implications of each for employer and employee.
5–3: Identify similarities and dissimilarities between various
types of nonqualified deferred compensation plans.
5–4: Analyze a situation to determine whether a nonqualified
plan would be appropriate.
5–5: Describe alternative methods available for funding
nonqualified plans and the advantages and disadvantages
of each method for employer and employee.
5–6: Identify similarities and dissimilarities between different
approaches for securing the employer’s promise to pay
deferred compensation.
5-4
Nonqualified vs. Qualified Plans
Characteristic
Nonqualified Plan
Qualified Plan
Discrimination;
ERISA requirements
Plan may discriminate;
certain plans are partially
exempt from ERISA
Plan may not discriminate;
all plans must satisfy
ERISA & IRC requirements
Employer deduction
Available in year of employee
taxation
Available in year of plan
contribution
Employee deferral
Tax deferred only if unfunded or
funds are at risk; no rollovers
Tax deferred until plan
distribution; rollovers allowed
Fund earnings
Earnings usually are currently
taxable to employer
Earnings accrue tax deferred
until distribution
Distributions
Taxed at ordinary rates;
averaging not available on lump
sums
Taxed at ordinary rates;
averaging may be available on
lump sums
Tax Treatment
5-5
Nonqualified Deferred Compensation
Type of Plan
Funding
Benefits
Uses
Pure deferred
compensation
Employee defers
current
compensation
Employer promises
deferred amounts plus
earnings at future rates
Employee can
defer taxation on
portion of earnings
Excess benefit plan
Funded or
unfunded
Retirement benefit is
calculated using company
qualified plan formula
without regard to §415
limits
To provide excess
benefits for selected
executives
Supplemental
executive
retirement plan
(SERP)
Funded or
unfunded
Retirement benefit is
calculated in excess of
qualified plan formula
To recruit mid-career
executives
Death benefit only
(DBO) Plan
Insurance or
deferred
compensation
Survivor protection in
excess of qualified plan
limits—benefits paid to
beneficiary are taxable
income
To benefit selected
executives
Supplemental Plans
5-6
Important Characteristics of Excess Benefit Plans, Top Hat Plans & SERPs
Type of
Plan
Participation
Restrictions
Source of
Benefits
Plan Benefit
Formula
Type of
Funding
Typical ERISA
Compliance
Excess
benefit
plan
Plan may be
established for
any
employee
(plan
typically is
established for
highly
compensated
employees).
Benefits
generally
are paid by
the
employer
out of
general
assets.
The plan’s benefit
formula may provide for
defined contributions
(separate account
funded by the employer
or employee salary
reduction
contributions); or a
defined benefit (salary
continuation benefits
funded by the
employer)
May be
funded or
unfunded
Unfunded excess benefit
plans are exempt from the
requirements of ERISA.
Funded excess benefit plans
are subject to the fiduciary,
written plan requirements,
and the enforcement and
claims provisions of ERISA.
However, funded excess
benefit plans are exempt
from other ERISA
requirements.
Top hat
plan
Plan can only
be established
for a select
group of
management
or highly
compensated
employees.
Same as
above
Same as above
Must be
unfunded
Top hat plans are subject to
brief reporting and disclosure
requirements, and the
enforcement and claims
provisions of ERISA.
However, top hat plans are
exempt from other ERISA
requirements.
SERP
Same as top
hat plan
Same as
top hat
plan
Same as top hat plan
Generally
unfunded,
but may be
funded
Same as top hat plan if
unfunded
5-7
ERISA Requirements for Nonqualified Deferred Compensation Plans
Reporting &
Disclosure
Participation, Vesting &
Funding
Fiduciary
Responsibility
Unfunded plan
or trust
Must comply
Exempt if top-hat plan;
must comply if plan
includes rank and file
Exempt if top-hat plan;
must comply if plan
includes rank and file
Funded plan
or trust
Must comply
Must comply
Must comply
Government and
church plans;
unfunded excess
benefit plans
Exempt
Exempt
Exempt
5-8
Section 409A Requirements for Nonqualified Deferred Compensation Plans
Deferral election
rules
Generally an unfunded NQDC plan must provide that the election for
deferral must be done no later than the close of the preceding tax year; a
new plan participant has 30 days to make a deferral election.
Time and form
of payments
Generally, the time at which distributions will be made and the form of
payments must be specified when the initial deferral election is made.
Permissible
distribution
events
Separation from service, death, disability or at the age, date, or fixed
schedule specified prior to the first deferral, at the change of control
effective ownership of the company, in the event of an unforeseeable
emergency, or at plan termination
Prohibition on
acceleration of
distributions
A distribution must be made on account of a permissible event. Otherwise,
an acceleration of distributions is not allowed. Generally, a change in the
form of a distribution that accelerates payments after they have already
commenced violates the rule prohibiting acceleration of distributions.
Time of
payments for
key employees
Key employees of public corporations may not receive benefits until six
months have elapsed since separation from service.
5-9
Death Benefit Only Plan
• Provide no lifetime payment to the employee
• The only benefit is the payment of a death
benefit to a designated beneficiary, and then
only if the employee dies while in active service
to the company.
5-10
Forfeiture Provision
• Requirement found in a
•
nonqualified deferred
compensation plan
Stating an employee’s
right to deferred
compensation payments
is contingent upon
satisfaction of some
stipulated condition, such
as future service.
5-11
Learning Objectives
5–1: Describe characteristics of nonqualified deferred
compensation plans.
5–2: Describe different types of nonqualified plans and the tax
implications of each for employer and employee.
5–3: Identify similarities and dissimilarities between various
types of nonqualified deferred compensation plans.
5–4: Analyze a situation to determine whether a nonqualified
plan would be appropriate.
5–5: Describe alternative methods available for funding
nonqualified plans and the advantages and disadvantages
of each method for employer and employee.
5–6: Identify similarities and dissimilarities between different
approaches for securing the employer’s promise to pay
deferred compensation.
5-12
Is a nonqualified plan appropriate?
Situation
•
XYZ Corporation has a handful of
highly paid executives.
•
Under the formula of the company’s
qualified retirement plan, each should
receive retirement benefits equal to
60% of his or her final annual salary.
•
Unfortunately, the ERISA cap on the
absolute amount that can be paid to
an individual will reduce the
retirement benefits of these
executives to an amount that ranges
from 25% to 40% of their final
salaries.
What can the company do to
improve the retirement income of
these executives?
o
The situation can be partially
remedied by an excess benefit
plan, the intention of which is to
overcome the limitations imposed
by the ERISA cap on individual
benefits.
o
However, an excess benefit plan
can be used only to make a
participant whole for the loss of
benefits caused by the IRC
Section 415 limits—not the loss
of benefits caused by the
qualified plan compensation limit.
o
Therefore, a “top hat” plan, not
an excess benefit plan, is usually
the best choice for employees
who earn considerably more
than the qualified plan
compensation limit.
5-13
Is a nonqualified plan appropriate?
Situation
• A merger with another corporation has forced
a large company to thin its managerial ranks
in several departments.
• Early retirement, offered on a targeted basis,
is one of the devices the company plans to
use to reduce its head count
How could nonqualified deferred
compensation be used for this
purpose?
• Because nonqualified plans are exempt
from most of the requirements of ERISA,
they are highly flexible and may be
designed to meet any number of business
and employee objectives.
• They can include some employees and not
others. They can include higher levels of
compensation or other conditions to which
the employer and employee agree.
• To encourage early retirement by
management or highly compensated
employees, for example, the company may
employ a SERP. It could be structured to
provide regular income—or a lump sum—
to fill the income gap between the date of
early retirement and the date at which the
employee would be entitled to receive
Social Security benefits and retirement
income from the company’s qualified
retirement plan.
5-14
Learning Objectives
5–1: Describe characteristics of nonqualified deferred
compensation plans.
5–2: Describe different types of nonqualified plans and the tax
implications of each for employer and employee.
5–3: Identify similarities and dissimilarities between various
types of nonqualified deferred compensation plans.
5–4: Analyze a situation to determine whether a nonqualified
plan would be appropriate.
5–5: Describe alternative methods available for funding
nonqualified plans and the advantages and disadvantages
of each method for employer and employee.
5–6: Identify similarities and dissimilarities between different
approaches for securing the employer’s promise to pay
deferred compensation.
5-15
Funding of Nonqualified Deferred Compensation Plans
Type of Plan
Benefits
Uses
Funded plans
Account established for employee; not
available to company’s creditors
Must have substantial risk
of forfeiture to defer taxation
Secular trust
Irrevocable trust; usually without any
substantial risk of forfeiture
No substantial risk of forfeiture, Employee
pays tax currently on contributions and
earnings
Unfunded or
informally
funded plan
Employer promises to pay benefit;
available to company’s general
creditors
No constructive receipt if:
• agreement prior to work
• funds available to creditors
Employer establishes general reserve
to fund future benefits Employee has
no beneficial interest
Taxation deferred if no constructive receipt
Unfunded
plan
Employer pays promised benefits from
future cash flow
Promise to pay is not constructive receipt
Rabbi trust
Irrevocable trust, available to general
creditors of company; provides security
of funded plan and tax deferral of
unfunded plan
Taxation deferred because assets are
available to company’s general creditors
5-16
Key Terms in Nonqualified Deferred Compensation
Description of Term
Tax-Deferral Action
Constructive
receipt
• Funds are credited to employee’s
account or made available to employee
• Right to receive benefit is unrestricted
• Employee could elect current payment
(even if deferred payment is chosen)
• Provisions establishing substantial
risk of forfeiture (funded plans)
or
• Availability of funds to company’s
general creditors (unfunded plans)
must be specified in plan
Substantial
risk of
forfeiture
•
Plan must provide for loss of rights to
payments if substantial services are
not performed OR if employment
terminates for reasons other than
death or disability
Generally only relevant in funded plans
(and unfunded plans with post-service
election)
• Employee’s right to payments must be
contingent upon future performance of
substantial services (death and disability
do not create)
5-17
Rabbi Trust
• Established by the employer
•
•
to provide funds to satisfy its
nonqualified plan obligations
to employees.
Considered “informally
funded.”
Assets are available to the
employer’s creditors.
5-18
Rabbi Trust
Requirements
• No “insolvency or financial
triggers”
• Assets cannot be located
outside of the United States
• Trustee must be notified if
company faces financial
crisis, and funds are frozen
so that funds are available
to the company’s general
creditors
5-19
Secular Trust
• Irrevocable funded trust for the exclusive benefit of
the employees
o prevents employer’s creditors from getting funds
o prevents employees from becoming subject to
future tax rates that may be higher than current
tax rates
• Contributions are taxable income to employees
• Employer subject
to certain ERISA
requirements
5-20
Third-Party Guarantees
Employees may arrange for a third party to pay
deferred benefits if the company fails to make
good on its promise:
• bank letter of credit
• a surety bond
• indemnity insurance
• if paid by employer, may lead to plan considered
funded, or
at least employer’s
payment is taxable
income to participants
• cost may be prohibitive
for employees
5-21
Question 1
Which one of the following is a characteristic
common to both qualified plans and nonqualified
deferred compensation plans?
a.
b.
c.
d.
written agreement
benefits may not be assigned or alienated
automatic survivor benefits must be provided
employer contributions are subject to employee
income limits
5-22
Question 2
Which one of the following is a possible
disadvantage of a nonqualified deferred
compensation plan?
a. It gives the employer little flexibility in targeting
plan benefits.
b. It can only be designed as a salary reduction
agreement.
c. Income tax rates may actually be higher by the
time an executive retires.
d. The benefits are immediately taxable to the
employee.
5-23
Question 3
Susan Edwards is the president of research and development for
Bionic Pharmaceutical, and she earns an annual salary of
$600,000. Susan will be entitled to an annual retirement benefit
equal to $130,000 under the formula of the company’s qualified
defined benefit plan. Which one of the following nonqualified
deferred compensation plans should be used to make Susan
whole for the loss of benefits caused by the qualified plan
compensation limit?
a. excess benefit plan
b. top hat plan
c. pure deferred compensation plan
d. rabbi trust
5-24
Question 4
John’s company put $80,000 in deferred compensation into
an account in his name and for his benefit. Although the
plan will not release these funds to John until his
retirement, it will allow him access to these funds in the
case of a foreseeable emergency. Which one of the
following rules determines the tax implications of this
arrangement for John?
a.
b.
c.
d.
constructive receipt doctrine
economic benefit doctrine
substantial risk of forfeiture doctrine
qualified joint and survivor annuity
5-25
Question 5
Which one of the following is a characteristic of a
SERP?
a.
b.
c.
d.
A SERP can cover any employee.
A SERP can be either funded or unfunded.
Automatic survivor benefits must be provided.
Contributions are limited by 415c.
5-26
Chartered Retirement Planning CounselorSM
Professional Designation Program
Module 5
End of Slides
©2013, College for Financial Planning, all rights reserved.