The frequent changes in the tax law limiting the benefits of 401(k) plans and other tax-qualified benefit plans for higher compensated individuals have placed additional burdens on plan sponsors to provide these individuals with substitute benefits. One offshoot of these changes is that nonqualified deferred compensation plans have been the subject of renewed interest among both employers and employees.
A nonqualified deferred compensation plan is relatively easy to operate since it is not subject to the many rules that govern tax-qualified plans. The ease of operation and the fact that a nonqualified plan allows an employer to reward certain employees without subjecting them to current taxation makes such a plan an attractive option from the employer's perspective. There are other aspects of this type of plan that employers find attractive. For example, unlike other salary deferral plans, nonqualified deferred compensation plans have no coverage rules. They have no vesting schedules. They have no contribution requirements. Moreover, the employer can pick and choose which employees he or she wishes to participate in the plan.
Essentially, a deferred compensation plan permits an individual to defer compensation so that it is not taxed until a future date. Employees who do not need money currently and expect to be in a lower tax bracket sometime in the future are the most likely candidates for such a plan.
Nonqualified plans can be funded or unfunded. A funded plan involves the employer's setting aside the deferred amounts for the benefit of the employee. With a funded plan, tax deferral occurs only if: (a) the employee's interest in the deferral is subject to the risk of forfeiture and (b) the employee's interest is nontransferable. The employee has to pay tax on the deferred amounts as soon as they become either nonforfeitable or transferable.
Unfunded plans are generally more common than funded plans. They are essentially an unsecured promise by the employer to pay an employee in the future for certain services. As long as the arrangement consists of that promise to the employee, then the employee is not in constructive receipt of the deferred income and does not have to pay taxes on the deferred amounts. Nonetheless, a common criticism leveled at unfunded plans is that, in this era of mergers, takeovers, and leveraged buyouts, a firm's new owners may not honor such a promise.
In an attempt to bypass the drawbacks found in both funded and unfunded nonqualified deferred compensation plans, financial advisors will often recommend that an employer set up a nonqualified deferred compensation trust. These trusts, also known as "rabbi trusts," consist of the employer's placing deferred compensation in a trust for the benefit of the employee. The deferred compensation placed in the trust remains subject to the claims of the employer's creditors. The deferred compensation is not taxed to the employee until he or she receives it.
The trust assets may not be assigned to beneficiaries by the employee. Further, the employee generally has access to the deferred compensation only on retirement, at the end of a specified time period, in a case of financial hardship, or upon a change of ownership of the employer. The employer can fund a rabbi trust in a variety of ways. For example, he or she can fund the trust through the use of a life insurance policy or an annuity contract.
There's little doubt that nonqualified deferred compensation plans are an effective means of easing the burden on highly compensated employees. Careful planning is crucial. Please call. We can help.
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