Currently, many employers sponsoring qualified retirement plans such as 401(k) would like to be able to offer their more highly compensated employees a chance to contribute significantly more on a pretax basis for their personal retirements. However, nondiscrimination tests governing how qualified retirement plans must be administered will often prevent these highly compensated employees from contributing at a higher level. Employers who fail nondiscrimination tests must either refund a portion of the contributions made by or for highly compensated employees, or they must make an additional required contribution for all non-highly compensated employees. How then can companies give key employees such as corporate officers an opportunity to contribute more dollars on a pretax basis? One alternative is for the employer to establish a non-qualified deferred compensation plan. Such plans give employers a tool that enables them to legally discriminate against non-highly compensated staff. As a matter for fact, in non-qualified deferred compensation plans, employers are required to discriminate at some level.
Deferred compensation plans allow owners to favor their best employees without adhering to the strict funding and participation guidelines of qualified plans. For example, with defined contribution qualified retirement plans such as 401(k)s the maximum annual deferral limit in 2009 is $16,500.00. Individuals over the age of 50 will be allowed to contribute an additional $5,000.00 over and above the $16,500.00 in deferrals and a combined employer and employee contribution is $49,000.00. Non-qualified retirement plans however, have no such limits on salary deferral contributions, nor are there any limitations on employer matching or profit sharing contributions.
Non-qualified plans also do not entail the reporting and disclosure requirements of qualified plans. For example, qualified retirement plans must undergo a variety of tests, these can include the average deferral percentage (ADP) test, the average contribution percentage (ACP) test, as well as an annual top-heavy test. Furthermore, most qualified retirement plans must require the filing of a tax return known as Form 5500. For these reasons, most plan sponsors retain an outside administrator firm to perform the various required tests and services.
Just as importantly, non-qualified plans do not have the fiduciary responsibility and liability of qualified plans. With qualified retirement plans, employers and plan sponsor representatives have fiduciary responsibility for retirement plan assets. They are required to administer these assets for the exclusive benefit of the retirement plan participants. The liability associated with retirement plan assets is both corporate and personal. In other words, plan sponsors acting in a fiduciary capacity have their personal assets exposed to liability if they’re found not to have managed the retirement plan in accordance with the law. Non-qualified deferred compensation plans carry none of these fiduciary exposures.
One unique type of non-qualified deferred compensation plan is referred to as a 401(k) mirror plan. This is a type of unfunded, non-qualified deferred compensation plan, which meets the top hat exemption of ERISA. The plan allows executives to defer some or all of their current income, and avoid current income tax on this deferred compensation. The amount deferred is credited to an account that may either grow at a fixed rate or be tied to a variable rate of return, such as a mutual fund or variable insurance sub-account. One interesting aspect of this 401(k) mirror plan is that from the participating employee’s standpoint, the interface and overall feel of the plan is very much like that of a traditional 401(k) retirement plan. For example, participants actually enter trades and view account balances through a secure website.
As with traditional deferred compensation plans, the executive making the contribution has no ownership rights in any particular asset and is simply a general creditor of the employer to the extent of the account balance. The employer owns any asset purchased to offset the liability created by the plan. This substantial risk of forfeiture must by law exist for these plans to be viable. Consequently, it is important that the executive participating in the 401(k) mirror plan be confident in the strength and stability of the sponsoring firm.
The employee pays no income taxes on the amount deferred into the plan, and also incurs no tax on contributions made to the plan on the employee’s behalf by the employer. However, when the employee ultimately receives the benefit during retirement, the income is taxed at ordinary income tax rates. At this point, as distributions are being paid to the participant, the employer receives a corresponding income tax deduction. Again, this arrangement is significantly different from qualified retirement plans where the executive has a vested, non-forfeitable interest in the qualified plan assets and the employer gets a current tax deduction for the contribution made to the plan.
A properly designed 401(k) mirror plan may increase a company’s ability to attract and retain top executives in the marketplace. The additional salary deferrals and potential employer contributions to the non-qualified plan can be very attractive to a senior executive. These types of plans can over time, dramatically increase a participant’s potential retirement income. Furthermore, longer vesting schedules for these benefits may more closely tie that valuable employee to the organization over a longer period of time.
The most commonly used funding vehicle for these types of non-qualified plans is corporate owned life insurance. For that reason, highly compensated employees who participate in such plans may also receive pre/ post-retirement death benefits.
Understandably, this alternative is popular with corporations that sponsor deferred compensation plans because of how life insurance cash values are taxed when owned by a corporate entity. The growth of corporate owned life insurance cash values is in fact tax deferred. Other common investment vehicles, including mutual funds and variable annuities, have earnings that create taxable income for corporations.
Non-qualified deferred compensation plans have significant design flexibility. Employers, for example, are able to be extremely creative in how they design their eligibility requirements for the plan. Eligibility requirements can be driven by a number of factors, including years of service, hours or position in the firm. Furthermore, from a design standpoint, the employer’s contribution is also extremely flexible. It can be based on any formula desired by the corporation’s management. For example, it could be based on specific performance objectives or on the employee’s tenure with the corporation. Thus, an employer’s creativity and flexibility are not constrained by the government’s nondiscrimination tests for traditional qualified plans.
In conclusion, for those employers who are comfortable giving up the ability to take current income tax deductions on employee salary deferrals and employer contributions, non-qualified deferred compensation plans can provide numerous benefits. Some of these benefits include increased flexibility from a plan design standpoint, enhanced retirement contributions for plan participants, additional tax savings for these highly compensated employees, and ultimately, better retention of these same key employees.
Dean Piccirillo offers insurance products through HBK Sorce Insurance LLC. Investment advisory services are offered through HBK Sorce Advisory LLC d/b/a HBKS Wealth Advisors. Mr. Piccirillo is not able to transact business in a state that he is not licensed or registered.
NOT FDIC INSURED. NOT BANK GUARANTEED. MAY LOSE VALUE, INCLUDING LOSS OF PRINCIPLE. NOT INSURED BY ANY STATE OR FEDERAL AGENCY.