By Douglas L. Hall
Insurance can be a tedious subject, especially when it deals with more complex issues like deferred compensation plans (often funded with different types of life insurance) for select employees.
But it can be a valuable tool for business owners. Review this article to help you boil down to the essentials, and maybe you can skip the introductory seminar.
A deferred compensation plan can help reduce current income taxes and supplement future retirement income for select employees, as well as yourself. This plan is often used to attract, motivate and retain high-quality employees. It’s especially appealing because taxes can often be deferred until retirement, when the plan participant might be in a lower tax bracket.
And because it is a nonqualified plan, a business can select any employee from its executive or management ranks to participate. There are no contribution limits and no significant filing or reporting requirements. However, note that contributions are not tax deductible until benefits are paid out to participants and benefits may be taxable to participants when they have the right to receive them — not necessarily when they are actually paid.
There are four basic steps to establishing a deferred compensation plan:
Choosing the employees who will be included in the plan and selecting the benefits that will be included under the plan (retirement income, disability benefits, death benefits, etc.) and the events that will trigger the payment of benefits.
Deciding where the salary deferrals will come from — paid from current salary or paid from current salary but deferred until a later date (salary reduction or salary continuation).
Selecting the funding vehicle — if life insurance, the purchase of a cash value life insurance policy on each plan participant.
Paying benefits after a “trigger” event — usually retirement, disability or death.
Deferred compensation plan benefit payments become a tax deduction for the employer and are taxed as ordinary income to the participant (or his or her beneficiary if a death benefit). If properly structured, a portion of the life insurance proceeds can be used to reimburse the employer for premiums and/or benefits paid.
There is more than one type of deferred compensation plan. Here are a few from which to choose:
Defined contribution plan: The amount contributed each year on behalf of participants is established under the plan agreement.
Defined benefit plan: This specifies the amount each participant will collect at retirement.
Salary reduction plan: Participants agree to defer a portion of their current salary (or bonus) to a future point in time — usually retirement — allowing them to postpone paying taxes on that income until they are likely to be in a lower tax bracket.
Salary continuation plan: The employer agrees to provide participants with additional compensation over and above their future salary, but defers payment of that additional compensation until a later date — in most cases retirement. This type of plan is often called a supplemental executive retirement plan (SERP).
There are many additional details that go into developing a deferred compensation plan. But we promised you an article, not a seminar. And the hope is that you now want to learn more.
Deferred compensation plans benefit your organization as well as the key employees you select. Your business can gain some tax advantages and help you keep your most valued executives and management members. Your business/professional adviser will work through the many details with you when you are ready.
So, why not get started? Now that you know the basics, it might be time to discover if a deferred compensation plan can add tremendous value to your business.
Douglas L. Hall is a partner in the Conshohocken office of 1847Financial.