Important Types of Non-Qualified Plans

There are four major nonqualified plans that differ from each other principally in terms of their benefit emphasis.  Certain plans emphasize death benefits while others emphasize retirement income; some plans enable an employer to recover its costs while others enable the employer to take a current income tax deduction (generally as compensation rather than as a plan contribution).  

The major nonqualified plans are:

Deferred compensation plans
Split dollar plans
Executive bonus plans, and
Group carve out plans

Let's take a brief look at each of them before examining them in detail later in this course.

 Deferred Compensation

Nonqualified deferred compensation plans can be further classified as:

True deferred compensation plans (salary reduction plans), or
Salary continuation plans

The principal difference between these two deferred compensation plan types lies in whose money is used to provide the benefit.  In the case of a true deferred compensation plan, the executive actually delays the receipt of income.  Often, but not always, the income whose receipt is delayed is a raise or a bonus.  In the case of a salary continuation plan, the executive gives up no current income.  Instead, the salary continuation plan is funded solely by the employer.  

There are certain other differences between these two types of deferred compensation plans.  The other differences, however, result from the difference in payers.

 Split Dollar

Split dollar plans may be used in virtually any situation in which a person with cash is interested in assisting a person with a life insurance need to purchase the needed life insurance.  A concerned father, for example, may want to assist his daughter's husband to purchase needed life insurance; in such a case, the resulting split dollar plan is known as private split dollar.  

In the majority of cases, however, split dollar plans are used in an employee-employer situation, wherein an employer may pay some or all of the premiums on a permanent life insurance policy under which the employee is the insured and which provides the bulk of the death benefit to the employee's personal beneficiary.  If the employee were to die during the life of the split dollar plan, the employer's interest could be limited to a recovery of its aggregate premiums.  It is on the use of split dollar in the employee-employer relationship that the balance of our split-dollar discussion will be focused.

A split dollar plan, when used in an employee-employer situation, is an arrangement under which a permanent life insurance policy is purchased on the life of a key executive, and the premiums and death benefits are split between the employer and the executive (or a third party).  The policy may be owned by the executive or by the employer, and the policy's ownership has a significant impact on the tax treatment given to the plan.

 Executive Bonus Plans

Executive bonus plans are the simplest of nonqualified plans by far.  Under an insured executive bonus plan, an employer agrees to pay some or all of the premiums on a life insurance policy owned by an executive.  The employer's premium payments are deductible to the employer as compensation paid to an employee.  As a result, the premium payments are included in the executive's W-2 statement, and the executive must include the premiums in his or her income for tax purposes.

 Group Carve Out Plans

A group carve out plan is an arrangement under which an employer replaces the executives' group life insurance in excess of $50,000 with individual universal life insurance policies.  These individual universal life insurance policies are owned by the respective executives.

The value of group life insurance in excess of $50,000 is taxable to the group participant.  By the employer's eliminating all of the group life insurance over this tax-free amount, the participant avoids the imputed income resulting from the excess group life insurance.  The employer then takes the premium that it would have paid for the replaced excess group life insurance and uses it to make payment on the participant-owned universal life insurance policies that replaced the group life insurance.

As we can see in the hypothetical before and after group carve out shown in the chart below, the total death benefits need not change as a result of the group carve out plan.  The only change -- and that may be fairly significant -- is the change from all group term life insurance to part group term life insurance and part universal life insurance.

Hypothetical Group Carve Out
Death Benefits Before Group Carve Out
Death Benefits After Group Carve Out
 Group life insurance death benefit
     $        250,000
     $            50,000
  +  Universal life insurance death benefit
     +                    0
     +           200,000
 Total death benefit
     $        250,000
     $           250,000