1. ©2013, College for Financial Planning, all rights reserved. Module 5 Individual Deferred Compensation Chartered Retirement Planning Counselor SM Professional Designation Program

2. Learning Objectives 5–1: Describe characteristics of nonqualified deferred compensation plans. 5–2: Describe different types of nonqualified plans and the tax implications of each for employer and employee. 5–3: Identify similarities and dissimilarities between various types of nonqualified deferred compensation plans. 5–4: Analyze a situation to determine whether a nonqualified plan would be appropriate. 5–5: Describe alternative methods available for funding nonqualified plans and the advantages and disadvantages of each method for employer and employee. 5–6: Identify similarities and dissimilarities between different approaches for securing the employer’s promise to pay deferred compensation. 5-2

3. Questions to Get Us Warmed Up 5-3

4. Learning Objectives 5–1: Describe characteristics of nonqualified deferred compensation plans. 5–2: Describe different types of nonqualified plans and the tax implications of each for employer and employee. 5–3: Identify similarities and dissimilarities between various types of nonqualified deferred compensation plans. 5–4: Analyze a situation to determine whether a nonqualified plan would be appropriate. 5–5: Describe alternative methods available for funding nonqualified plans and the advantages and disadvantages of each method for employer and employee. 5–6: Identify similarities and dissimilarities between different approaches for securing the employer’s promise to pay deferred compensation. 5-4

5. Nonqualified vs. Qualified Plans CharacteristicNonqualified PlanQualified Plan Discrimination; ERISA requirements Plan may discriminate; certain plans are partially exempt from ERISA Plan may not discriminate; all plans must satisfy ERISA & IRC requirements Tax Treatment Employer deductionAvailable in year of employee taxation Available in year of plan contribution Employee deferralTax deferred only if unfunded or funds are at risk; no rollovers Tax deferred until plan distribution; rollovers allowed Fund earningsEarnings usually are currently taxable to employer Earnings accrue tax deferred until distribution DistributionsTaxed at ordinary rates; averaging not available on lump sums Taxed at ordinary rates; averaging may be available on lump sums 5-5

6. Nonqualified Deferred Compensation Type of PlanFundingBenefitsUses Pure deferred compensation Employee defers current compensation Employer promises deferred amounts plus earnings at future rates Employee can defer taxation on portion of earnings Supplemental Plans Excess benefit planFunded or unfunded Retirement benefit is calculated using company qualified plan formula without regard to §415 limits To provide excess benefits for selected executives Supplemental executive retirement plan (SERP) Funded or unfunded Retirement benefit is calculated in excess of qualified plan formula To recruit mid-career executives Death benefit only (DBO) Plan Insurance or deferred compensation Survivor protection in excess of qualified plan limits—benefits paid to beneficiary are taxable income To benefit selected executives 5-6

7. Important Characteristics of Excess Benefit Plans, Top Hat Plans & SERPs Type of Plan Participation Restrictions Source of Benefits Plan Benefit Formula Type of Funding Typical ERISA Compliance Excess benefit plan Plan may be established for any employee (plan typically is established for highly compensated employees). Benefits generally are paid by the employer out of general assets. The plan’s benefit formula may provide for defined contributions (separate account funded by the employer or employee salary reduction contributions); or a defined benefit (salary continuation benefits funded by the employer) May be funded or unfunded Unfunded excess benefit plans are exempt from the requirements of ERISA. Funded excess benefit plans are subject to the fiduciary, written plan requirements, and the enforcement and claims provisions of ERISA. However, funded excess benefit plans are exempt from other ERISA requirements. Top hat plan Plan can only be established for a select group of management or highly compensated employees. Same as above Must be unfunded Top hat plans are subject to brief reporting and disclosure requirements, and the enforcement and claims provisions of ERISA. However, top hat plans are exempt from other ERISA requirements. SERPSame as top hat plan Generally unfunded, but may be funded Same as top hat plan if unfunded 5-7

8. ERISA Requirements for Nonqualified Deferred Compensation Plans Reporting & Disclosure Participation, Vesting & Funding Fiduciary Responsibility Unfunded plan or trust Must complyExempt 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 Funded plan or trust Must comply Government and church plans; unfunded excess benefit plans Exempt 5-8

9. Section 409A Requirements for Nonqualified Deferred Compensation Plans Deferral election rules Generally an unfunded NQDC plan must provide that the election for deferral must be done no later than the close of the preceding tax year; a new plan participant has 30 days to make a deferral election. Time and form of payments Generally, the time at which distributions will be made and the form of payments must be specified when the initial deferral election is made. Permissible distribution events Separation from service, death, disability or at the age, date, or fixed schedule specified prior to the first deferral, at the change of control effective ownership of the company, in the event of an unforeseeable emergency, or at plan termination Prohibition on acceleration of distributions A distribution must be made on account of a permissible event. Otherwise, an acceleration of distributions is not allowed. Generally, a change in the form of a distribution that accelerates payments after they have already commenced violates the rule prohibiting acceleration of distributions. Time of payments for key employees Key employees of public corporations may not receive benefits until six months have elapsed since separation from service. 5-9

10. Death Benefit Only Plan Provide no lifetime payment to the employee The only benefit is the payment of a death benefit to a designated beneficiary, and then only if the employee dies while in active service to the company. 5-10

11. Forfeiture Provision Requirement found in a nonqualified deferred compensation plan Stating an employee’s right to deferred compensation payments is contingent upon satisfaction of some stipulated condition, such as future service. 5-11

12. Learning Objectives 5–1: Describe characteristics of nonqualified deferred compensation plans. 5–2: Describe different types of nonqualified plans and the tax implications of each for employer and employee. 5–3: Identify similarities and dissimilarities between various types of nonqualified deferred compensation plans. 5–4: Analyze a situation to determine whether a nonqualified plan would be appropriate. 5–5: Describe alternative methods available for funding nonqualified plans and the advantages and disadvantages of each method for employer and employee. 5–6: Identify similarities and dissimilarities between different approaches for securing the employer’s promise to pay deferred compensation. 5-12

13. Is a nonqualified plan appropriate? Situation XYZ Corporation has a handful of highly paid executives. Under the formula of the company’s qualified retirement plan, each should receive retirement benefits equal to 60% of his or her final annual salary. Unfortunately, the ERISA cap on the absolute amount that can be paid to an individual will reduce the retirement benefits of these executives to an amount that ranges from 25% to 40% of their final salaries. What can the company do to improve the retirement income of these executives? o The situation can be partially remedied by an excess benefit plan, the intention of which is to overcome the limitations imposed by the ERISA cap on individual benefits. o However, an excess benefit plan can be used only to make a participant whole for the loss of benefits caused by the IRC Section 415 limits—not the loss of benefits caused by the qualified plan compensation limit. o Therefore, a “top hat” plan, not an excess benefit plan, is usually the best choice for employees who earn considerably more than the qualified plan compensation limit. 5-13

14. Is a nonqualified plan appropriate? Situation A merger with another corporation has forced a large company to thin its managerial ranks in several departments. Early retirement, offered on a targeted basis, is one of the devices the company plans to use to reduce its head count How could nonqualified deferred compensation be used for this purpose? Because nonqualified plans are exempt from most of the requirements of ERISA, they are highly flexible and may be designed to meet any number of business and employee objectives. They can include some employees and not others. They can include higher levels of compensation or other conditions to which the employer and employee agree. To encourage early retirement by management or highly compensated employees, for example, the company may employ a SERP. It could be structured to provide regular income—or a lump sum— to fill the income gap between the date of early retirement and the date at which the employee would be entitled to receive Social Security benefits and retirement income from the company’s qualified retirement plan. 5-14

15. Learning Objectives 5–1: Describe characteristics of nonqualified deferred compensation plans. 5–2: Describe different types of nonqualified plans and the tax implications of each for employer and employee. 5–3: Identify similarities and dissimilarities between various types of nonqualified deferred compensation plans. 5–4: Analyze a situation to determine whether a nonqualified plan would be appropriate. 5–5: Describe alternative methods available for funding nonqualified plans and the advantages and disadvantages of each method for employer and employee. 5–6: Identify similarities and dissimilarities between different approaches for securing the employer’s promise to pay deferred compensation. 5-15

16. Funding of Nonqualified Deferred Compensation Plans Type of PlanBenefitsUses Funded plansAccount established for employee; not available to company’s creditors Must have substantial risk of forfeiture to defer taxation Secular trustIrrevocable trust; usually without any substantial risk of forfeiture No substantial risk of forfeiture, Employee pays tax currently on contributions and earnings Unfunded or informally funded plan Employer promises to pay benefit; available to company’s general creditors No constructive receipt if: agreement prior to work funds available to creditors Employer establishes general reserve to fund future benefits Employee has no beneficial interest Taxation deferred if no constructive receipt Unfunded plan Employer pays promised benefits from future cash flow Promise to pay is not constructive receipt Rabbi trustIrrevocable trust, available to general creditors of company; provides security of funded plan and tax deferral of unfunded plan Taxation deferred because assets are available to company’s general creditors 5-16

17. Key Terms in Nonqualified Deferred Compensation Description of TermTax-Deferral Action Constructive receipt Funds are credited to employee’s account or made available to employee Right to receive benefit is unrestricted Employee could elect current payment (even if deferred payment is chosen) Provisions establishing substantial risk of forfeiture (funded plans) or Availability of funds to company’s general creditors (unfunded plans) must be specified in plan Substantial risk of forfeiture Generally only relevant in funded plans (and unfunded plans with post-service election) Employee’s right to payments must be contingent upon future performance of substantial services (death and disability do not create) 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 5-17

18. Rabbi Trust Established by the employer to provide funds to satisfy its nonqualified plan obligations to employees. Considered “informally funded.” Assets are available to the employer’s creditors. 5-18

19. Rabbi Trust Requirements No “insolvency or financial triggers” Assets cannot be located outside of the United States Trustee must be notified if company faces financial crisis, and funds are frozen so that funds are available to the company’s general creditors 5-19

20. Secular Trust Irrevocable funded trust for the exclusive benefit of the employees o prevents employer’s creditors from getting funds o prevents employees from becoming subject to future tax rates that may be higher than current tax rates Contributions are taxable income to employees Employer subject to certain ERISA requirements 5-20

21. Third-Party Guarantees Employees may arrange for a third party to pay deferred benefits if the company fails to make good on its promise: bank letter of credit a surety bond indemnity insurance if paid by employer, may lead to plan considered funded, or at least employer’s payment is taxable income to participants cost may be prohibitive for employees 5-21

22. Question 1 Which one of the following is a characteristic common to both qualified plans and nonqualified deferred compensation plans? a. written agreement b. benefits may not be assigned or alienated c. automatic survivor benefits must be provided d. employer contributions are subject to employee income limits 5-22

23. Question 2 Which one of the following is a possible disadvantage of a nonqualified deferred compensation plan? a. It gives the employer little flexibility in targeting plan benefits. b. It can only be designed as a salary reduction agreement. c. Income tax rates may actually be higher by the time an executive retires. d. The benefits are immediately taxable to the employee. 5-23

24. Question 3 Susan Edwards is the president of research and development for Bionic Pharmaceutical, and she earns an annual salary of $600,000. Susan will be entitled to an annual retirement benefit equal to $130,000 under the formula of the company’s qualified defined benefit plan. Which one of the following nonqualified deferred compensation plans should be used to make Susan whole for the loss of benefits caused by the qualified plan compensation limit? a. excess benefit plan b. top hat plan c. pure deferred compensation plan d. rabbi trust 5-24

25. Question 4 John’s company put $80,000 in deferred compensation into an account in his name and for his benefit. Although the plan will not release these funds to John until his retirement, it will allow him access to these funds in the case of a foreseeable emergency. Which one of the following rules determines the tax implications of this arrangement for John? a. constructive receipt doctrine b. economic benefit doctrine c. substantial risk of forfeiture doctrine d. qualified joint and survivor annuity 5-25

26. Question 5 Which one of the following is a characteristic of a SERP? a. A SERP can cover any employee. b. A SERP can be either funded or unfunded. c. Automatic survivor benefits must be provided. d. Contributions are limited by 415c. 5-26

27. ©2013, College for Financial Planning, all rights reserved. Module 5 End of Slides Chartered Retirement Planning Counselor SM Professional Designation Program