Broker Check

Utilizing Nonqualified Retirement Plans as Fringe Benefits

July 19, 2022

Creative Ways to Keep Key Employees

Employee turnover is expensive and losing key personnel can have devastating effects on a company. Organizations are often coming up with new ways to recruit talented people and offer their best workers incentives to remain instead of seeking positions elsewhere.  Nonqualified retirement plans can sometimes be that “extra something” that rewards and retains the best of their workforce.

Retirement Plans for Employees

Approximately 50 percent of US companies offer employees a retirement plan as part of their benefits package. The statistic is heavily skewed based on company size, i.e., about one-third of small companies (20 or less employees) offer retirement benefits compared to 98 percent of large companies (5,000 or more employees). Most of these plans are considered qualified plans, i.e., they are federally approved after meeting IRS requirements. Such plans fall underneath the Employee Retirement Income Security Act of 1974 (ERISA) that was enacted to protect retirement funds of US employees within private industry. There is much reporting required and employers are obligated to stay apprised of any changes in retirement plan laws and regulations. However, qualified plans allow employers an attractive tax break on the contributions made on behalf of employees.

Some common qualified plans are as follows:

  • 401(k) plan
  • 403(b) plan
  • Pension plan
  • Profit-sharing plans
  • Employee stock ownership plans (ESOP)
  • Money purchase plans

Why Consider Executing a Nonqualified Plan?

While many workers have come to expect a retirement plan as part of an organization’s benefit package, it is not enough for some high-earning employees. ERISA guidelines provide that contributions or benefits do not discriminate in favor of highly compensated employees. All employees are to receive equal benefits from the retirement plans, so the IRS set regulations to ensure against highly compensated employees contributing much more to tax-free plans and lowering their tax liability in a way that is out of reach for other workers. That means that highly compensated employees are limited in the size of contributions they can make.  

This is where a nonqualified plan could come in. Such plans do not come with the tax advantages that qualified plans do, but they are free from the IRS regulations and ERISA guidelines. Companies can come up with innovated ways to provide additional retirement plans to compensate high earners. Two popular nonqualified plans are an Executive Bonus Plan and Supplemental Executive Retirement Plan (SERP).

Executive Bonus Plan

In this plan an employee owns a permanent life insurance policy. He/she selects a beneficiary and has access to the cash value. The employer “bonuses” money to cover the costs of premiums. Sometimes an employer will “double bonus” to cover the income taxes created by the premium payment compensation. This plan is very straightforward, making it easy to administer. A written agreement is drawn up to ensure both sides understand how the plan will be executed, e.g., whether the premium payments will be paid directly or indirectly.

Occasionally, companies will want to retain control over the cash value of the policy. This would  mean restricting access to the cash value rights until a stated retirement date or when a length-of-service requirement is reached. The reasons for this may be to help prevent the key employee from starting a competing business or simply to add an incentive for the employee to stay with the company. A separate agreement, called a custodial executive bonus arrangement, is executed to the restriction.

There are several advantages to employing this plan:

  • Easy to administer
  • Limited reporting requirements
  • Selectivity in choosing participants (not ERISA regulated)
  • Premiums paid are tax-deductible
  • Executive access to the policy’s cash value
  • Usable with an annuity or disability insurance instead of life insurance

Supplemental Executive Retirement Plan (SERP)

Since high earners are restricted by the amount they can contribute to a qualified retirement plan, they may look for ways to enhance their income when they stop working. A SERP may be the answer as it is a written agreement to pay an employee a steady stream of retirement income or a lump sum at retirement. Since it is outside ERISA regulations, employers can be selective in whom is offered such an arrangement while enjoying flexibility in its execution. Companies normally purchase a life insurance plan on the employee to fund the plan. When the executive retires funds are paid out from company cash flow and/or the cash value of the policy. When the executive dies the company can then recoup the costs it paid out.

There are several advantages to employing this plan:

  • Easy to administer
  • Limited reporting requirements
  • Selectivity in choosing participants (not ERISA regulated)
  • No contribution limits
  • Company-deductible retirement payments
  • Employees taxed only when retirement benefits are received
  • Employer owns the policy and controls its cash value
  • Recoverable costs via the policy death benefit
  • Tax-free life insurance proceeds paid to the company

Since this is a supplemental retirement plan, there is an inherent “golden handcuffs” feature to its structure. Employers often offer a fringe benefit to a high-earning key employee to keep him/her with the company, as the executive knows that he/she cannot collect on the plan until a certain date.

Other Nonqualified Retirement Plans

Some other plans to consider are Deferred Savings Plan, Split-Dollar Arrangement and Group Carve-Out Plan. Non-qualified plans never qualify for the same favorable tax treatment as qualified plans do. However, correctly structured plans enjoy tax advantages . Tax professionals and financial advisors should always be consulted before proceeding with any arrangement discussed here. This is particularly important if the company owner is participating in one of these plans. Consulting with experts is the first step in structuring that win/win plan to benefit both employer and employee.