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New Rules Under §409A Have Taken the Wind Out of Deferred Compensation PlansNew Rules Governing Deferred Compensation Have Created a Problem For Many Employers With Traditional Plans - It May Be Time To Look At New AlternativeWilliam L. MacDonald
By all accounts, today’s executive talent pool is slowly evaporating. Companies across America are preoccupied with the recruitment function because it has become challenging to find well-seasoned managers to lead into the future. That’s why it is now crucially important for companies to offer a well-balanced executive compensation and benefits package that includes specialized retirement and nonqualified deferred compensation (NQDC) plans. The process begins with a compensation and benefits strategy, as shown in Chart I. Most companies tend to focus more on the compensation side and don’t really take advantage of the many innovative concepts on the benefits side.
Assuming success in recruitment, companies can motivate newly hired executives with NQDC plans because the plan’s inherent structure creates reward and retention incentives. Traditional NQDC plans are attractive to companies; they prefer the flexibility of design and ability to vary benefits within a single plan, thus satisfying different participant needs. These arrangements allow management to single out a “select group of highly compensated and/or management personnel.” Traditional deferred compensation plans are a popular executive benefit program because of the advantage that pre-tax savings has over other alternatives. Chart II shows the power of compounding money on a tax-deferred basis.
The executive’s employer sponsors the plan and provides the leverage that makes these plans so attractive. With a traditional NQDC arrangement, the executive is permitted to save on a pre-tax basis. In exchange, however, the employer defers a current tax deduction to a future date when the compensation is paid to the executive. In effect, the plan sponsor provides the executive with a loan which the executive is free to invest in any of the plan’s investment options—usually mutual funds similar to the 401(k) plan. At retirement, or a pre-selected date, the NQDC is paid to the executive. The executive effectively pays the “loan” off with interest by paying taxes on the distribution at ordinary income tax rates (see Chart III). The company finally receives its deduction when the compensation is paid.
Typically, traditional NQDC plans are financed with tax-advantaged corporate-owned life insurance (COLI). Alternatively, mutual fund investments can be selected as the funding mechanism. With COLI, amounts earned on the cash value are not subject to current taxes. Thus, the amounts can accumulate and compound as pre-tax dollars, eventually covering liabilities of the deferred compensation arrangement. The executive selects the mutual fund and invests the cash value earnings. To fund the retirement obligation, the company can borrow against the policy in future years using the cash value on a non-taxable cash flow basis simply by borrowing against the policy. Should the participant die early, the policy delivers a current death benefit that permits the corporate policyholder to meet the liability and, quite possibly, recover plan costs.
Some NQDC Disadvantages It is important to point out that traditional NQDC arrangements are not without issues. First, they can be expensive because the company has to fund the NQDC plan upfront without tax deductions. And, even though the company policyholder is the beneficiary of the death benefit, the participant may not pass for many decades, which means “repayment” to the company, the actual death benefit, is also postponed that length of time. Consider this example: A company sets aside $50,000 a year into a traditional NQDC plan over 15 years for a 50-year-old executive. We assume the deferred amounts (i.e., $50,000 per year) will earn 8.5%, which would produce a $169,987 annual benefit starting at age 65 and paid for 15 years. Each year during the executive’s accumulation period, the company loses $20,000 (in the 40% corporate tax bracket) due to its inability to deduct the compensation at that time. To hedge its liability, the company deposits $50,000 (equal to the amount deferred) into premiums in a corporate-owned life insurance policy. The company is also the beneficiary of the policy. As illustrated in Chart IV, when the executive dies (assumed at age 82), the company will receive a non-taxable life insurance benefit that will recover all of its costs and produce a net present value gain to the company.
Limitations Under IRC Rule 409A The potential to strengthen NQDC’s began to emerge with the passage of 409A. This new tax code section, IRC Rule 409A came about under the American Jobs Creation Act of 2004, and impacts all NQDC arrangements for all amounts deferred on or after January 1, 2005. In one fell swoop, the legislation specified that all current and prior compensation deferrals will be taxed—regardless of the amount, source, or from whom the deferral is made, if the plan is not in compliance; that is, the terms of the plan under which the deferrals were made fail to comply with the new rules. In part, 409A places limits on payout elections and further restrictions on what constitutes death, disability, termination, and hardship. The most significant prohibitions surround the acceleration of benefits: Haircut or penalty provisions for early withdrawal are no longer permissible, nor are petitions for early distributions; contract renegotiation or benefits restructurings are eliminated and, finally, there can be no plan terminations or liquidations. These restrictions increase the concerns executives have with regard to being “unsecured general creditors” of their employers. In addition to the security risk, the current low tax environment exposes executives to the risk of higher tax rates at the time of cash withdrawals from their NQDC plan. Deferred compensation distributions, as discussed above, can only be taken as taxable distributions, subject to the then-applicable ordinary income tax rates. Current combined marginal income and capital gains tax rates are quite low by historical standards and the Democratic congress and presidential candidates aren’t hiding their desire to increase all marginal tax rates on upper income earners. If rates increase, it will likely be less efficient to defer at this time into what may prove to be a higher future tax bracket. The bottom line is executives would be wise to start planning now for aggressive tax hikes (Chart V).
IRC 409A extends its impact on NQDC plans even more broadly by encompassing the timing of deferral elections, changes in payout time and form, exclusion of offshore trusts, and the stoppage of any trigger events with regard to financial and health matters. Add to this, IRS reporting requirements have also been expanded. Fortunately, IRS Notice 2005-1 pushes out the deadline to bring NQDC plans into compliance until to December 31, 2008. Companies have only a few months to make a decision to terminate an existing plan and do so in a way that does not unwittingly trigger those penalties outlined in the American Jobs Creation Act of 2004. This extension offers the perfect time to evaluate deferred compensation plans before the close of the year, and every company should make this important effort. Even so, plan sponsors with traditional NQDC plans are still perplexed on next steps. To grandfather an existing plan, a company may be compelled to freeze it and stop future contributions. If so, the company could find itself in a position of having no plan going forward or developing a new plan to comply with legislation.
New Alternatives Available—The Executive Roth PlanSM When a company opts to terminate an existing plan without an alternate plan in place, retirement planning ends up in the hands of the key employee. At this point, it is important to develop options that do not restrict, limit, or cost more. One option is the Executive Roth Plan. In this scenario, the company can take the compensation deductible as the funding deductible. The Executive Roth Plan is very simple:
One of the disadvantages of an after-tax plan is the loss of invested principal each year due to taxes (on contributions, not earnings). The employee receives the bonus as income, and then deposits the after-tax contribution into the Executive Roth Plan (i.e., $50,000 pre-tax compensation, minus $20,000 taxes at 40%, equals $30,000). At the participant’s discretion, after-tax contributions to the plan can be supplemented by a tax restoration account internal to the insurance contract. This feature will allow the executive to restore the taxes paid through the “tax restoration” feature within the policy, so that the pre-tax amount is invested as shown in Chart VI.
The optional tax restoration loan is non-recourse with no required prepayment except through policy proceeds at surrender or death. By restoring the taxes, the executive defers the impact of the taxes and similar leverage to a traditional pre-tax plan, without the limitations or restrictions. The Executive Roth Plan is also in the executive’s control and not subject to the employer’s general creditors. The appeal of the Executive Roth Plan is deductibility. The plan is able to function outside regulatory scrutiny because the participant pays taxes on the bonus (contributions to the plan). If this weren’t the case, contributions would fall under the IRC 409A. However, there is a small detractor to the Executive Roth Plan: required annual deposits. To cover the related insurance cost, even though they are low, requires at least 5 deposits in the first 10 years. The plan allows the participant to skip a year or two; however, as with any systematic savings plan, the participant should contribute regularly. Because the employee owns and controls the account, there is no “retention” element to the plan. The employee is 100% vested on their contributions, which is why some companies prefer the more “glue-in-the-seat” aspect of traditional NQDC arrangements under the new rules, and structure the Executive Roth Plan as a plan design feature. Under this arrangement, the company contributions would go into the traditional plan. Once the employees have vested, they would then roll the savings into the Executive Roth Plan. The employee could also tax-defer their compensation short-term, and use the Executive Roth Plan in later years. With this design feature, the executive would tax-defer compensation in the traditional NQDC plan, and use short-term distribution features to flow dollars into the Executive Roth Plan. Chart VII gives us an example of an executive deferring $200,000 into their traditional tax-deferred plan. He or she then elects to take distributions in years 2, 3, 4, and 5, with those distributions going into the Executive Roth Plan.
Conclusion The Executive Roth Plan is not subject to deferred-compensation-related regulations or the restrictions of IRC 409A. As a result, it is a sound alternative for companies that have a need to attract, retain, and reward their key employees. The Executive Roth Plan gives employers needed flexibility and selectivity on fringe benefit for key executives without the administrative burden and long-term liability of a traditional plan. Many companies prefer Executive Roth Plans for the company deduction, and the way they help to considerably reduce costs and impact on overall cash flow. Employees prefer the Executive Roth Plan because they can better protect themselves. They own the plan outright and are no longer subject to the company’s general creditors, thus protecting their own retirement nest egg. Executive Roth Plans provide a current death benefit and may be designed to provide asset protection and/or estate tax planning flexibility. Unlike traditional NQDC plans, future retirement benefits are non-taxable if the insurance policy is held until death. A participant in an Executive Roth Plan can use the tax restoration loan to get tax-deferred accumulation similar to that afforded to participants in traditional NQDC plans. At least we now know what we are up against with new set of rules and regulations governing NQDC plans. While these regulations have weakened these arrangements, the best tonic to restore vitality may well become the Executive Roth Plan.
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