How Pension Law Affected Nonqualified Deferred Compensation

The trend of tax law in the qualified retirement plan area is one of increasing costs, increasing limitation on the amount of benefits that may be provided to highly paid and owner-employees, and decreasing employer discretion and control.

Planners should point out that each of the following points pertaining to changes in the qualified retirement plan area makes nonqualified plans an appealing alternative:

First, regardless of how much the retiree was earning prior to retirement, the amount that can be paid to that person from a defined benefit pension plan is severely restricted. As of 2012, the maximum yearly benefit that can be distributed from a defined benefit plan is only $200,000 (indexed for inflation), or, if lower, 100 percent of the participant’s average three years’ compensation.67 Furthermore, a reduction must be made if the plan under which the payments will be made contains a pre-age sixty-five normal retirement age, or if the plan participant has fewer than ten years of service.

Second, as of 2012, the ceiling on the annual additions that can be added by an employer to the account of a plan participant in a qualified defined contribution (e.g., money purchase) plan—­regardless of how much he or she is earning–is only $50,000 (indexed for inflation), or, if less, 25 percent of compensation.

Third, all qualified retirement plans are limited with respect to the maximum compensation that can be used in computing either benefits or contributions. As of 2012, the maximum compensation that can be considered in computing a plan’s permissible benefit distribution or annual additional contribution for an individual is the first $250,000 (indexed for inflation) of his annual compensation.

The result of these rules is a severe restriction upon the benefits that may be provided to the highly paid and owners of the business—the people who work the hardest and add the most to the profits of the employer. Consequently, these same individuals will receive the least of all employees as a percentage of average pay before retirement. For example, an executive earning $500,000 a year who is covered under a 10 percent money purchase plan is credited with not 10 percent of $500,000, but only 10 percent of $250,000. He receives no credit for the other $250,000 of salary earned—even though he’s taxed on all $500,000!

Fourth, participants in most qualified plans must become fully vested twice as quickly as was required under pension law just a few years ago. While this means fewer forfeitures from an employee viewpoint, benefit costs have increased significantly from an employer’s perspective.

Fifth, tougher nondiscrimination rules place additional restraints on an employer’s discretion with respect to who can be excluded from plan participation. This not only increases costs, but also reduces the employer’s ability to direct cash flow to those who make the greatest contribution to it.

Sixth, Social Security integration rules (now referred to by the IRS as permitted disparity) have been changed to further favor rank-and-file employees, which further adds to employer costs.

For other answers to frequently asked questions surrounding pension law, visit here.

Reproduced with permission.  Copyright The National Underwriter Co. Division of ALM

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