©2015, College for Financial Planning, all rights reserved.

Session 14Fundamentals of Deferred Compensation

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits

Session DetailsModule 8Chapter(s)

1, 2

LOs 8-1 Identify characteristics of a nonqualified deferred compensation plan.

8-3 Identify characteristics of a given form of informal funding for a private, unfunded nonqualified deferred compensation plan.

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Definition of Nonqualified Deferred Compensation

“A nonqualified deferred compensation plan means any plan that provides for the deferral of compensation.” American Jobs Creation Act of 2004 – IRC Section 409A

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Nonqualified Deferred Compensation Overview

409A—Increased restrictions on deferred

compensation• Nonqualified plans are ideal for business

owners and key employees who want to provide benefits for themselves in excess of qualified plan limitations

• The historically low personal income tax brackets make nonqualified deferred compensation less attractive than previously

• The prospect of rising taxes in the future also makes nonqualified deferred compensation less attractive

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Nonqualified vs. Qualified Plans

Characteristic Qualified Plan Nonqualified PlanInternal Revenue Code RequirementsDiscrimination Plan may not discriminate Plan may discriminateERISA Requirements

All plans must satisfy ERISA and IRC requirements

Certain plans are partially exempt from ERISA

Tax TreatmentEmployer deduction

Available in year of plan contribution

Available in year of employee taxation

Employee deferral Tax-deferred until plandistribution; rollovers allowed

Tax-deferred only if unfunded or funds are at risk; no rollovers

Fund earnings Earnings accrue tax-deferred until distribution

Earnings usually are currently taxable to employer

Distributions Taxed at ordinary rates;averaging may be available on lump sums

Taxed at ordinary rates; averaging not available on lump sums

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Types of Nonqualified Deferred Compensation

• Pure deferred compensation (employee funded)

• Supplemental plans (employer funded)o Excess benefit plano Supplemental Executive Retirement

Plan (SERP)o Death Benefit Only plan (DBO)—

provides a survivor benefit

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Excess Benefit Plans• An excess benefit plan is linked indirectly to the

qualified plan or plans in place and provides for benefits in excess of the amount to which the employee would otherwise be entitled under the qualified plan

• The payment is typically made when the employee retires and is usually paid out the same way that benefits are paid under a qualified retirement plan

• The plan may be funded, informally funded, or unfunded

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Supplemental Executive Retirement Plans (SERPs)

• A SERP (or top hat plan) is an unfunded plan providing benefits for select employees (generally only high-level executives) in excess of those provided by the employer’s qualified retirement plan o Benefits are usually based on elements of

compensation not otherwise provided under the qualified plan (such as a benefit formula with a higher multiple of earnings or ignoring altogether Social Security integration levels)

• SERPs can be used for a broader range of purposes than excess benefit plans

• Unfunded SERPs are exempt from all but the reporting and disclosure requirements of ERISA

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Nonqualified Deferred Compensation Tax Implications

To employer• Deduction when

taxed to employee• Earnings taxed to

employerTo employee• Taxed when benefit

constructively received

• Subject to FICA taxes when constructively received 14-9

ERISA Requirements for Nonqualified Deferred Compensation Plans

ERISA

Reportingand Disclosure

Participation,Vesting, andFunding

FiduciaryResponsibility

PlanTerminationInsurance

Unfunded Plan or Trust

Must comply Exempt if top-hat plan; must comply if plan includes rank and file

Exempt if top-hat plan; must comply if plan includes rank and file

Exempt if top-hat plan; must comply if it includes rank and file

Funded Plan or Trust

Must comply Must comply Must comply Must comply

Government, Church, Unfunded Excess Benefit Plans

Exempt Exempt Exempt Exempt

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Nonqualified Deferred Comp Funding

Unfunded• Promise to pay• Agreement executed prior to service performance• Available to company creditorsFunded• Not available to employer’s creditors• Currently taxable to employee unless substantial risk of

forfeiture Informally Funded • Employer “informally” dedicates

assets to employee through accounting device or segregating assets to a trust

• Rabbi Trust an example

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Rabbi Trust• A rabbi trust is an

employer-sponsored irrevocable grantor trust

• Trust has two beneficiaries:o the employee ando creditors of the

company• Trust earnings are

currently taxable to the employer

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Secular Trust• Irrevocable fully funded trust established

for an employee• Employee is vested in contributions,

so current taxation to employee results

• Assets are not subject to the claims of an employer’s creditors

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Requirements for Deferral of Taxation

IRS Regulations stipulate three principles that must be followed for deferred compensation:1. The agreement to defer compensation must

be made before the dollars are earned2. The agreement must represent only an

unsecured promise3. The agreement cannot be funded (i.e., any

funds used to provide the benefit must be held by the employer as a general asset available to creditors)

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Substantial Risk of Forfeiture• Employee’s right to payments must be

contingent upon future performance of substantial services (death or disability are not considered substantial services)

• Plan must provide for loss of rights to payments if substantial services are not performed OR if employment terminates for reasons other than death or disability

• Generally only relevant in funded plans

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Constructive Receipt• The constructive receipt issue isn’t

whether the taxpayer has actually received the income, but whether he or she has access to it

• To avoid constructive receipt, agreements usually contain specific provisions establishing substantial risk of forfeiture (funded plans), or availability of funds to company’s general creditors (unfunded plans)

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Economic Benefit• Economic benefit relates to the receipt of

non-cash property that can be valued in cash

• When the employee’s benefit is treated as the equivalent to the receipt of cash, current income taxation will result

• In unfunded and unsecured plan, mere promise to pay does not confer economic benefit

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Question 1Manning Manufacturing wants to implement a nonqualified deferred compensation plan that will enable the company to set aside the same 10% they are contributing into the profit sharing plan for amounts executives earn above the IRC qualified plan compensation limit. You would recommend a(n) a. SERP.b. death benefit only plan.c. rabbi trust.d. excess benefit plan.

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©2015, College for Financial Planning, all rights reserved.

Session 14End of Slides

CERTIFIED FINANCIAL PLANNER CERTIFICATION PROFESSIONAL EDUCATION PROGRAMRetirement Planning & Employee Benefits