Understanding Deferred Compensation In Life Insurance Policies

Deferred compensation plans are a way for employees to put off paying taxes on their income beyond what they can do with a regular retirement plan. Life insurance is one way to fund these arrangements. With this system, employees can delay taxes while building future retirement income, and employers are covered in the event of an employee's death.

Non-qualified deferred compensation plans

A non-qualified deferred compensation (NQDC) plan is a way for executives and other top-earning employees to delay taxes on income beyond what they can do with a regular retirement plan. It is a binding contract between an employer and an employee where the employer agrees to pay the employee at a later time. The employer makes an unsecured promise to pay an employee's future benefits, subject to the specific terms of the contract.

With non-qualified deferred compensation plans, an employer can offer bonuses, salaries, stock options, retirement plans other than 401(k)s, and other kinds of compensation without having to make the payments right away. These plans differ from qualified plans, like a 401(k), which have stricter rules investors must follow and typically have an income cap. Non-qualified deferred compensation plans are not limited by income, and employees can defer as much income as they want.

NQDC plans are not regulated by the Employee Retirement Income Security Act (ERISA) and are therefore more flexible. Employers are not required to offer these plans to all employees and often only offer them to top-level executives or exceptional talent. There are no limits on how much an employee or employer can contribute to an NQDC plan, although the employer is subject to the IRS reasonable compensation requirement for deductibility purposes.

NQDC plans can be beneficial for employees as they allow them to reduce their current taxable income and withdraw funds when their income is likely lower, such as during retirement. By collecting income after they've stopped earning their larger income, employees can put themselves into a lower income tax bracket, which may help them pay less tax on the money in the long run.

However, there are also drawbacks to NQDC plans. For example, employees must schedule distributions in advance and cannot withdraw funds at will after retirement. Additionally, NQDC plans do not offer the same protections from creditors as other retirement plans, and employees do not own an account of any kind. If the employer falls on hard times, the funds that might have been used to pay employee distributions can be claimed by creditors.

Life insurance can be used to fund NQDC plans. Employers can use life insurance to cover the future promised payments to the employee. The life insurance builds cash value and would pay the employee's heirs if they die before retiring. There are two types of non-qualified deferred compensation plans that allow life insurance funding: supplemental executive retirement plans (SERPs) and corporate-owned life insurance (COLI).

Supplemental Executive Retirement Plans (SERPs)

SERPs are a non-qualified retirement plan offered to executives as a long-term incentive. They are not subject to the Employee Retirement Income Security Act (ERISA) and are therefore more flexible than a qualified plan. They are not limited by income, and employees can defer as much income as they want.

SERPs are beneficial to both the company and the employee. Companies use SERPs as a way to reward and retain key executives. They are easy to implement, require no IRS approval, and allow companies to decide which employees will receive the benefit. The employer can structure the life insurance policy to recover its costs, and they receive a tax deduction when the benefits are paid out.

For employees, the plan can be tailored to meet their specific needs. Supplemental retirement income can be accumulated without incurring upfront taxes, and death benefits are available to provide a lump-sum payment to the family in the event of the executive's death.

However, it is important to note that SERPs do have some disadvantages. The company does not get an immediate tax deduction on premium payments, and the funds that accumulate inside the life insurance policy used to fund the SERP are not protected from creditor claims if the company goes bankrupt.

Corporate-owned life insurance (COLI)

COLI was originally purchased on the lives of key employees and executives by a company to hedge against the financial cost of losing them to unexpected death, the risk of recruiting and training replacements, or to fund corporate obligations to redeem stock upon the death of an owner. This use is commonly known as "key man" or "key person" insurance.

COLI policies are a way for a company to minimize its tax burden, increase after-tax net income, finance employee benefits, and help cover the expenses associated with replacing an insured employee upon that employee's death. COLI policies typically continue to cover employees up to a year after they leave the company.

Because some insurance companies used COLI policies to exploit tax loopholes, the Internal Revenue Service now requires that they meet certain conditions to receive a tax-free death benefit. For example, the company can only purchase COLI policies for the top 35% of employees, ranked according to their compensation. In addition, it must notify the employee in writing of the terms of the policy and obtain their written consent before purchasing.

Today, COLI is most common for senior executives of a firm, but its use for general employees is still sometimes practiced. According to one source, Hartford Life Insurance estimated that one-quarter of all Fortune 500 companies have COLI policies, which cover the lives of about 5 million employees.

Tax advantages

Deferred compensation plans are a type of savings plan that allows employees to defer a portion of their income, which is then paid out at a later date, usually during retirement. These plans are often used as a strategy to attract and retain top talent and can be a helpful tool for recruiting and retaining quality employees.

Life insurance is sometimes used as a funding mechanism for deferred compensation plans, and there are several tax advantages to this approach for both employers and employees.

• Employees can defer income tax on their contributions and investment earnings until benefits are paid out, usually during retirement, when they may be in a lower tax bracket.
• By collecting income after they've stopped earning their larger income, employees can put themselves into a lower income tax bracket, potentially paying less tax on the money in the long run.
• Employees can also benefit from the tax-free growth of the cash value of the life insurance policy over time.
• Employers can deduct their contributions to deferred compensation life insurance plans, providing tax savings.
• When deferred benefits are paid out to the employee or their beneficiaries, the company can deduct the amount of the benefit payments.
• The death benefit paid to the employer is usually tax-free, allowing the company to recover the costs of the plan.
• Premium payments made by the company with the employee's deferrals are not tax-deductible until future benefits are paid.

Overall, the use of life insurance to fund deferred compensation plans can provide tax advantages for both employers and employees, contributing to a financially beneficial strategy for all parties involved.

Control and flexibility

Non-qualified deferred compensation plans offer control and flexibility to both employers and employees.

For employers, the plans allow them to choose which employees are eligible to participate. They are not required to offer these plans to all employees and can instead use them to reward select top-performing or highly compensated executives. This gives businesses greater selectivity and helps them retain key talent.

For employees, non-qualified deferred compensation plans give them control over when they would like to receive their money and how they would like to receive it (as a lump sum or incremental payments). Employees can also reduce their current taxable income and withdraw funds, which have been able to grow tax-deferred, when their income is likely lower (e.g., in retirement).

However, it is important to note that non-qualified deferred compensation plans do not allow for early withdrawals. Employees cannot access this money before the specified date, and there is also no investment component, so employees cannot diversify their holdings or pursue market returns.

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