Employers and employees are equally interested in supplementing their retirement income. Doing this on a tax-privileged basis is always a plus. While life insurance is typically viewed as a death benefit for the beneficiaries and assets of an insured person, it can also be used to provide the insured person with a substantial livelihood.
There are two funding methods that are primarily used to complement retirement: stocks and bonds, or a life insurance policy. For the purposes of this article we will discuss life insurance. In particular, one that builds significant present value and includes the minimum amount of death benefit coverage while maintaining the favorable tax treatment of an unmodified life insurance policy (MEC). This will maximize the additional payouts you can receive from an employee deferred compensation plan (DCP) or an additional owner retirement plan (SORP) for the business owner.
If your small business customer wants to reward employees for their loyal service after five, ten or 20 years, a DCP can work well as a “golden handcuff”. It gives an employer the ability to do something special to reward a particular employee or group of employees for their past or future work at their own discretion. In addition, it is only available if the employee meets certain pre-set conditions for meeting an employer’s employment requirements.
This can be done in a number of ways, allowing the specially selected employee to defer part of their current income to supplement their retirement income. If the employee is unable to defer part of their current income, the employer can loan the employee the money. If the employer so wishes, the amount can correspond to the deposits of a particular employee. Compared to a typical qualified plan, there are relatively few regulatory approvals, administrative costs, or regulatory requirements required to initiate or maintain such a plan.
A DCP is a contractual agreement between a company or other employer and one or more of its key executives, under which the company promises to pay benefits in the event of death, disability or retirement, provided the executive or business owner is employed by the company at the time of payment of the service.
The typical DCP is created in a written agreement between the two parties and should include the services to be provided by the employer and the services of the manager before they can receive those services. Although there are two types of plans, qualified and unskilled, I will focus on unskilled plans. In contrast to qualified pension plans, non-qualified DCPs can discriminate and only select highly paid executives / employees.
Unqualified plans are merely unsecured promises made by the employer to the employee and are not protected against financial failure by the company. If the policy is owned by the employer, the employee is merely a creditor to the company.
A similar plan can also be used to provide very attractive benefits to your business owner customers themselves. This can also be done at your own discretion. One of the key benefits of a SORPRP is that it uses a life insurance product specifically designed to minimize the aspect of life insurance protection and to maximize the tax deferred accumulation benefits associated with a permanent life insurance contract. The main advantage of a SORP, however, is that the policy owner can distribute the tax-free accumulations tax-free. This is done through a series of loans and returns, with which the normally distributed taxable profits are distributed 100% tax-free and can never be repaid as long as the policy outlives the insured.
Note that many of the existing non-guaranteed life policies that fund DCPs, SORPs, or SERPs for many of your customers need to be maintained on an ongoing basis to ensure that death benefit is paid does survive the insured. This needs to be done in order to maintain the various tax breaks that life insurance and this strategy normally offer. Many of these non-guaranteed policies are currently expiring prematurely due to years of reduced and sustained interest rates combined with neglect by the owners of these policies. Owners who did not know the premiums should have increased over the years ensure their policy did not expire prematurely.
Just as the goal in a tightly run company is always to use corporate assets for personal gain, a similar goal in designing a DCP should always be to use the lowest tax bracket available, be it for businesses or individuals . A strategically designed DCP often creates such alternative beneficial options when it comes to choosing between the employer’s lower tax bracket and the business owner / employee’s higher personal tax bracket.
Deferral to supplement a worker’s future retirement income may also provide some current benefits, including payroll tax savings and the Medicare 3.8% tax saving for both the employer and the employee.
The Newport Group, an organization that offers group benefits, recently surveyed members of Fortune 500 companies and found that 92% of them offer their employees a deferred compensation plan. The top three reasons for this were the provision of a competitive compensation program (83%), the ability for executives to accumulate assets to meet retirement needs (72%) and to retain valued executives (63%).
While there are no surveys on the implementation of DCPs OR SORPs in the tightly run business market, their use there is equally effective. They should only be implemented for tax reasons in order to provide tax breaks to the owners of the business.
Consider a situation where an employee or employer might consider a traditional deferred compensation plan or an add-on retirement plan for owners to provide additional retirement income. For example, a 45-year-old employee could defer $ 25,000 pre-tax into a deferred compensation plan funded by a life insurance policy that continues to increase their present value on a tax basis until the employee reaches age 65. At that point, the employee has 500,000 USD deposited after 20 years. Then, in year 25, at age 70, that employee could begin earning approximately $ 139,000 tax-free annually for the next 15 years up to age 85, while working for approximately $ 1 million Life insurance coverage could have been used to complete the plan if the manager or business owner had died prematurely.
Employers can choose to choose a traditional plan where workers pay for and own the policy themselves, or a nontraditional plan where the employer provides a loan
By using a split dollar agreement, the employee can continue to take full advantage of the inherent tax benefits on the distribution. For example, the employer could lend a selected employee the $ 25,000 annual security deposit. In this situation, employees would only have to pay tax on the $ 25,000 they actually didn’t receive. If the employer so wishes, they can also lend the employee the income tax, which is often referred to as a double bonus in a non-traditional DCP. In this case, the death benefit is used to repay the company for its expenses, with the remainder going to the worker’s family.
While only an employee of a C company is eligible to participate in a DCP, an employee of a Sub S, LLC, or other pass-through can take advantage of tax law, for example by setting up an unqualified DCP or SORP / individuals who have maxed out their 401 (k) contributions but still wish to defer additional current income to supplement their retirement years, could continue to make non-deductible deposits with an unqualified DCP / SORP. This way, they could benefit from the additional life insurance for their beneficiaries, continue to take advantage of the tax-deferred accumulation aspects of a 401 (k) plan while still being able to make 100% tax-free distributions at any time with no income restrictions and no early withdrawal penalties. It’s like a Roth IRA against steroids.
In summary, it can be said that many companies have already used the essential advantages of a strategically designed DCP. Statistics and hands-on observations as a seasoned practitioner show that these popular corporate perks are increasingly moving into the ranks of many smaller, tightly-run businesses as their advisors become increasingly familiar with the tax benefits and ease of administration involved in setting up a business plan and owner’s skill determine who can participate.
This column does not necessarily reflect the opinion of the Bureau of National Affairs, Inc. or its owners.
Information about the author
Henry Montag CFP, who has been the practice director of TOLI Center East since 1976, with offices in LI NY, has written articles and acted as the source for NYSBA, NYSSCPA, Bloomberg Tax’s Daily Tax Report and the Bloomberg Tax Estates Gifts & Trust Journal, Trusts & Estate Magazine, Accounting Today, and the Wall Street Journal.