Delivering Deferred Compensation Plan Benefits
There are typically three situations in which benefits under a deferred compensation plan may be payable at:
death before retirement. or
The methods normally used to provide the promised benefits are different, depending on which situation requires their payment.
Benefits at the Executive's Retirement
Paying the benefits at the key executive's retirement may be done using the employer's current income alone, or funds may be made available to the employer by accessing the asset used to informally fund the plan. Regardless of whether funding comes entirely from the employer's current income or by accessing a life insurance policy used as an informal funding asset, the employer has two options with respect to the policy:
The employer may surrender the policy, or
The employer may keep the policy in force.
The employer that surrenders the policy that informally funds a deferred compensation plan experiences two important consequences, both of them bad:
The employer will be required to recognize current income to the extent that the policy's cash value exceeds the employer's cost basis; the employer's cost basis is generally equal to its aggregate premium payments.
The employer forgoes its ability to recover its plan costs since the death benefits will no longer be payable.
Of course, the employer receives the policy's cash value on surrender and may use those funds in any way it chooses, including using them to pay the deferred compensation plan benefits. As a result of these two adverse consequences, however, employers using life insurance to informally fund the plan benefits will usually keep the policy in force.
If the employer elects to keep the life insurance policy in force, it may pay the retirement benefit out of its current earnings or may choose to take funds from the policy's cash value. To the extent that the employer accesses cash value, it will diminish the eventual death benefit. If the benefits are to be paid by using policy values and the life insurance policy used to informally fund the plan benefits is a whole life insurance policy (preferably a life paid-up at 65), the employer has probably used any dividends to purchase paid-up additional insurance. Upon commencement of retirement benefits, the employer can surrender sufficient dividend additions to pay the deferred compensation plan benefit. When dividends have been exhausted, the employer may begin making cash value loans.
The flow of funds in a universal life insurance policy is even more advantageous because of the availability of cash value withdrawals and their favorable tax treatment. The tax treatment enjoyed by withdrawals from a life insurance policy that has not been deemed a modified endowment contract (MEC) is known as first in, first out (FIFO). Under FIFO tax treatment, withdrawals are tax free until the policyowner has withdrawn an amount equal to its cost basis. Only then will withdrawals be taxable as ordinary income.
As a result of that tax treatment, employers generally choose to take withdrawals from the life insurance policy used to informally fund the deferred compensation plan benefit until they have recovered their cost basis. When their cost basis has been recovered, the employer then changes the cash value access to policy loans.
Since the payments made by the employer are tax-deductible and withdrawals are tax-free to basis, the employer enjoys a certain amount of tax leverage. For example, if the employer is a corporation in a 34 percent tax bracket, a $100,000 annual deferred compensation payment actually costs the employer $66,000; the other $34,000 comes from reduced income tax liability resulting from the tax-deductible payment. So, the employer would normally take a withdrawal equal to its net after-tax cost of $66,000.
Policy loans are also received tax free, provided the policy is not subsequently surrendered. (If surrendered, the outstanding loan balance is deemed to be a part of the surrender proceeds.) To make this arrangement even more favorable for the employer, the policy loan interest paid by the employer on policy loans under policies insuring a key person is deductible to the extent that the indebtedness does not exceed $50,000.
The retired executive receives the deferred compensation payments as taxable income in the year in which they are received.
Note of caution: The strategy of taking withdrawals to basis and then changing to policy loans to continue to receive the funds tax free is one that is used frequently; there is, however, a need to approach the strategy with some caution. If the policy is subsequently surrendered or permitted to lapse, the policyowner could experience a condition frequently referred to as "phantom income." Phantom income (in this context) means that the policyowner will experience taxable income as a result of lapse or surrender without having cash value funds with which to pay the tax liability that arises because of the termination of the contract.
Benefits at the Executive's Disability
Benefits that are payable under a deferred compensation plan at the executive's disability generally come from disability income policies paid for by the employer. These policies should be of the conditionally renewable variety, and continued renewability should be conditional on the executive's continuing to be employed by the employer. Conditionally renewable policies owned by the employer are not generally taken into consideration in determining the amount of disability income coverage available to the executive.
Disability income policies used to provide pre-retirement disability benefits pursuant to a deferred compensation agreement are normally owned by and payable to the employer. Since the policy is owned by, and benefits are payable to, the employer, premiums are not deductible. The disability benefit received by the employer is tax free; the benefit when paid to the executive is income taxable to the executive and tax-deductible to the employer.
Alternatively, an employer may elect to pay premiums on a disability income policy owned by the executive. In such a case, the premium paid by the employer is tax-deductible but is not taxable to the executive. The disability benefits, however, are taxable to the executive under this arrangement. If the executive and employer opt for this approach, i.e. payment of premiums on an executive-owned disability income policy, the deferred compensation plan agreement should clearly indicate that the employer's obligation is limited to the payment of disability income insurance premiums. If the disability income policy is owned by the executive, it will affect the executive's ability to obtain other disability income coverage.
Pre-retirement Survivor Benefits
If the executive covered under the deferred compensation plan dies while in the service of the employer, benefits will normally be paid to his or her survivors -- often at the level that would have been paid to the executive at retirement. Since the life insurance policy used by the employer to informally fund the deferred compensation plan benefits is owned by the employer who is also the beneficiary, the entire tax-free death benefit is paid to the employer when the executive dies.
Benefits are payable to the executive's survivors in accordance with the terms of the deferred compensation plan agreement. The benefits are considered taxable income when received by the survivors and tax-deductible when paid by the employer.
In some cases, employers and their executives choose to combine an employer-owned, endorsement-method split dollar plan with a deferred compensation plan. The advantages of that combination include:
Death benefits received by survivors are income tax-free, and
The employer's cost may be reduced slightly by the executive's payment of a portion of premiums equal to the economic benefit of the split dollar death benefit