Why is this Topic Important to Wealth Managers? Provides information on one additional planning tool that many wealth managers find useful for affluent clients who own a small business.  Gives an overview of the nonqualified plans as well as proving a common use of life insurance to fund plan obligations well into the future.    

Simply a nonqualified pension plan is a retirement plan that does not meet the requirements under the tax code and federal employment law to be considered qualified, and therefore the nonqualified plan is treated differently for tax purposes. [1]

What are some of the advantages of using a nonqualified plan over a qualified retirement plan? [2] 

• Flexibility and selectivity—because the plan is not subject to requirements under the qualified plan rules, employers have much more control in terms of who may be included and the varying terms of each individual participant. 
• Vesting and contingencies—nonqualified plans allow for the employer to exclude all amounts not met by vesting conditions or contingencies that the employee must achieve to obtain the benefit.  Say for example, that the retirement funds become available to the employee after 10 years of faithful service to the company.  If the employee does not work for 10 years, no benefits have thus accrued and the employee has no benefit under the plan. 
• Cost savings through minimal reporting requirements—since nonqualified plans do not usually fall within major regulatory scope of qualified plans, the cost to administer these plans is generally less than some alternatives.

How are nonqualified plans treated for tax purposes?

Employees are generally not taxed on the benefits received under a nonqualified plan until they actually receive the compensation. [3]  Accordingly, the deduction for employee benefits is generally not taken by the employer until the benefits are paid to the plan participant. [4]

In addition, many nonqualified plans include the purchase of life insurance.  Since the value of the policy may grow at a tax-free rate inside the insurance policy, when the time comes for the payment of benefits, the deduction taken by the employer will generally be much larger than a qualified defined contribution plan.  However, the event causing the payment of benefits may not occur until some time long into the future, therefore significantly delaying the deduction in time. 

One consideration that is essential to the creation of a proper nonqualified plan is a carefulness in avoiding constructive receipt—If the plan benefits are actually realized by the taxpayer, i.e., the participant has a present right to withdrawal from the pension, the amount will be taxable to the employee when the employee is said to have constructively received the income. One such instance can occur when an insurance policy is purchased to fund plan obligations, but the beneficiary is listed as the insured and not the business.  Since the employee realizes a current benefit it is a taxable event.  For a detailed discussion of the constructive receipt doctrine, see AdvisorFYI: All Together Now: Gross Income, Increase in Wealth, Realization, Barter, and Constructive Receipt, as well as Advisor Fx: Two Tax Doctrines: Constructive Receipt and Economic Benefit.

Tomorrow’s blogticle will discuss Section 1035 exchanges in today’s marketplace.

We invite your questions and comments by posting them below, or by calling the Panel of Experts.

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[1] Leimberg, Doyle.  Tools and Techniques of Life Insurance Planning, 4^th Ed.  493.  2007.  The National Underwriter Company.  Cincinnati, Ohio. (A Summit Business Media Co.) 

[2] Leimberg, Doyle.  Tools and Techniques of Life Insurance Planning, 4^th Ed.  At 494. 

[3] See generally 26 U.S.C. § 404. 

[4] 26 U.S.C. § 404 (a). 

Tags: Business, Compensation and Benefits, Constructive Receipt, Employee benefit, Financial services, Human Resources, life insurance, Pension

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