When to use Nonqualified Deferred Compensation

A nonqualified deferred compensation plan should be considered by planners using the same critical overlay and analysis as is appropriate with any other life insurance planning tool. There are no clear cut right or wrong answers, and there are no “no cost” solutions. The best course of action is to evaluate each of the viable alternative tools or techniques (such as Section 162 plans, split dollar life insurance, etc.) based upon the following criteria:

  • What is the relative tax efficiency based upon current and probable future tax rates?
  • What is the probability of achieving the employer’s objectives? In other words, what is the cost efficiency?
  • How important is an upfront income tax deduction to the employer?
  • Does the employer desire a lot of control (i.e., “golden handcuffs”) over the participating key employees?
  • What security does the tool provide against employer insolvency?
  • Does the plan provide security in the event of management or ownership changes?
  • Can the employer keep or obtain the use of plan funds for an emergency or opportunity?
  • How easy is it to implement, explain, and maintain the plan?

A nonqualified deferred compensation plan is indicated in the following situations:

  • When an employer has had enough of the qualified plan blues: increasing costs, decreasing employer discretion and control, and too many limitations on the benefits that may be provided to highly paid and owner-employees. In short, a nonqualified plan should be considered when an employer wants to decrease or eliminate the costs associated with a qualified plan.
  • When an employer would like to provide a retirement and/or death benefit to one or more key employees, but does not want the prohibitive cost or aggravation of a qualified plan or does not want to cover all the employees that must be covered under a qualified plan.
  • When an employer wants to provide additional benefits to an executive who is already receiving the maximum benefits or contributions under the employer’s qualified plan. Supplemental benefits provided to key individuals under a nonqualified plan provide an excellent means of overcoming the limits placed upon a qualified plan by Code section 415.
  • When an employer wants certain key employees to have tax deferred compensation in different amounts or under different terms or different conditions from that provided to other employees.
  • When an employer seeks to establish an automatic and relatively painless investment program that uses corporate tax deductions to leverage the employee’s future benefits. Because amounts paid by the corporation are generally deductible when paid, employer tax savings can considerably boost the amount payable to the key employee. For instance, suppose the employer is in a 40 percent combined federal and state bracket when benefits are paid. To pay benefits of $100,000 per year costs only $60,000, because a 40 percent deduction of the $100,000 distribution yields a $40,000 tax saving.
  • When an employer is seeking a tool to recruit, retain, retire, and reward key personnel without the limitations of a qualified plan.3 Because nonqualified deferred compensation plans work in closely held corporations, smaller firms can use them as a replacement for (or to compete against) the equity-based compensation packages, such as company stock or stock options that an employee of a publicly held company would expect to receive.

A nonqualified deferred compensation plan is generally not indicated when it is not likely that the business will survive the death, disability, or retirement of its key employees.

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

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