The DUFF TORNEY Team

Michael Torney, CFP, J.D., LL.M. 

Successful executives often receive various forms of compensation in addition to their salaries and bonuses. Their employers will often provide stock awards or the opportunity to participate in various long-term plans that may provide significant income, but also may be hard to understand. It’s important to know how these plans work, as well as how they affect long-term and retirement planning. 

Executive compensation plans fall into two categories, termed qualified and non-qualified deferred compensation. 

Qualified plans include a defined contribution plan, such as a 401(k)-retirement plan, or a defined benefit, such as a traditional pension plan. Non-Qualified plans take various forms, but often provide special ways for executives to either contribute additional money or receive deferred compensation from their employer later in their careers or at retirement.   

There are two kinds of non-qualified compensation: elective and non-elective plans.  A non-elective plan includes your salary and any bonuses. Elective plans involve ways to contribute or earn money over a long period where taxes are deferred.  

Many executives have the opportunity to earn significant sums from these non-elective plans. Here is a list of these plans and how they work: 

Top Hat Plans

As the name implies, these plans offer deferred compensation to a small group of high-ranking executives. The employer chooses who can participate and how much to contribute. They may offer executives a way to defer income into the plan during each calendar year or a plan is funded entirely by the employer. 

Generally, these plans do not need to undergo non-discrimination testing by government regulators. Members can contribute as much as they like, which is atypical in traditional retirement plans that face annual limits. However, contributions to top hat plans are immediately taxable, as are distributions of funds from these plans. These plans are unfunded, although owners can sometimes set aside funds (for example in a rabbi trust) for the plan as long as the assets remain subject to creditor claims in the event of insolvency. 

Excess Benefit Plans

These plans differ from top hat plans because they do not limit the amount of executives who can participate.  Once an executive hits the limit on the amount they can contribute annually to a 401(k)-retirement plan, an excess benefit plan enables them to contribute an additional amount beyond their 401(k), IRA or other retirement plans. 

This amount is owed to the executive later on, typically at or during retirement. What makes this different than a 401(k), a Roth 401k or a 403(b) is that an excess benefit plan is controlled by the employer and the funds in it are owed to the employee. So, while money in your IRA or 401(k) belongs to you from the start, funds in your excess benefit plan won’t until they are distributed. 

These plans can be funded or unfunded. If left unfunded, a business will pay the benefits due at the time they come due from business revenue and/or existing assets. Funded plans set aside a pool of assets to be earmarked for future benefits.  There are differing tax rules to the employee and the employer depending on if the plan is funded or unfunded. 

Supplemental Executive Retirement Plan (SERP)

Under this plan, the executive and their employer sign an agreement that promises the executive a certain amount of supplemental retirement income based on various performance conditions. A SERP generally takes on the form of a cash value life insurance policy. Companies buy an insurance policy of an agreed-upon amount for the employee. This plan does not have any immediate tax advantages. 

Stock Appreciation Rights (SARs) and Phantom Stock Plans

SARs are stock grants that entitle an executive to a specific number of company shares at a certain price. After the stock grant is made, SARs can become profitable if the company’s stock price rises after a pre-determined period. Of course, if the company’s stock does not appreciate, SARs will expire and the executive does not realize any profits. 

Phantom stock does not include actual shares in a company or any type of ownership or voting rights. Often used by private companies that don’t have publicly-traded stock, it is a way for owners to incentivize its key employees to stay with the company for a long period. 

The owners may eventually want to sell the company and know a potential buyer will want a strong management team in place. Holders of phantom stock, typically executives, can receive the value of their shares as income once a key event occurs, such as the executive’s retirement or the company’s sale.  

Restricted Bonus Plans

These plans often consist of a specialized life insurance policy which provides income-tax-free cash accumulation and retirement benefits. The plans often allow the executive access to the cash balance, without penalty, after the restriction period expires. There is often a safety net for the executive in the event of their death. 

Because each company has its own plans and its own set of rules, it can be challenging for executives to understand them. If your company provides you with a specific deferred compensation program and you would like to discuss them as part of an overall financial strategy, contact our team at Duffteam@monetagroup.com. We are always available to discuss how we can help people maximize their wealth.

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