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Deferred Compensation Alternative Allows Businesses to Reward and Retain Valuable Employees July 24, 2000 (Principal Financial Group) Highly paid employees frequently want to defer more current income but cannot because they are already making maximum contributions to a 401(k) plan. Nonqualified deferred compensation is an often-used solution, but does not provide the employer a current income tax deduction. This article discusses Deferred Compensation Alternative (DCA), which may be the answer where an employer wants an arrangement providing a current deduction, maximum simplicity and an incentive for key employees to stay.
How it Works
DCA provides a simple and efficient way for a business to reward and retain its most valuable employees. The employee sets aside either a percentage or a fixed dollar amount of after-tax income. To follow the 401(k) format and provide an incentive, the business matches the deferral through a tax deductible match. The employer can provide an additional bonus to cover the employee's tax costs on the deferral and match so that after-tax contributions are approximately equal to those under a 401(k).
The deferral and match are used to pay the premium on a financial vehicle, such as life insurance, annuities or mutual funds. The employee owns and controls the financial vehicle, which can be used to supplement retirement income. The program mimics the company 401(k) plan so the executive easily understands it, but it is not subject to qualified plan rules. Life and annuities are often used because they offer tax-deferred growth.
Tax Consequences
Because amounts paid are compensation under Internal Revenue Code Section 162, the employer receives a full deduction for the match as well as any additional bonuses paid to reduce the employee's out-of-pocket costs on the match or deferral. Of course, total compensation must not be unreasonable or excessive.
No employer deduction is allowed if the employer is a direct or indirect beneficiary of the insurance policy. Additionally, the employer cannot have the right to receive any cash values from the policy or annuity; or any portion of any death benefit. Employer Control
A common employer objection to this type of arrangement is the lack of control. Two methods, a restrictive endorsement and an employment contract, are available to address this concern.
A restrictive endorsement can limit the executive's access to cash values for a specific period of time -- usually a set period of years or until retirement. An endorsement is placed on the policy preventing the employee from surrendering the policy for its cash value, assigning the policy as collateral security, or changing ownership of the policy without employer consent until the predetermined time.
The restrictive agreement does not give the employer any rights in the contract, it simply prevents the employee from taking loans or withdrawals from the contract without the employer's consent. The values can never revert to the employer.
An employment agreement provides greater employer control and, if desired, allows the employer to recover premiums paid under the DCA arrangement. If the employee leaves the company before retirement or a specified period of time, the employment agreement provides that the employee must repay all or part of the bonuses paid.
Typically such a contract includes a vesting schedule stating the amount to be repaid based on years of service. However, the employee owns and controls the policy and can take it if he or she leaves. The employment agreement cannot be secured by the policy and the policy and the agreement are not tied in any way.
Summary
Deferred Compensation Alternative arrangements provide a simple and efficient nonqualified deferred compensation arrangement that allows companies to reward and retain their most valuable employees on a tax deductible basis. Including a restrictive endorsement and an employment agreement in the arrangement provides the employer with some control over the policy and the employee with incentive to remain with the company.
Please send your comments, questions and article proposals to information@smartpros.com.
2000, Principal Financial Group. All Rights Reserved.
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