Deferred Compensation

Attract and Keep Top Notch Employees

In today's highly competitive business environment can make or break profitability? Salary is only part of it, and there are limits to pension plan contributions. ”Deferred compensation” is a simple benefit that can further both your business, as well as selected employees. Deferred Compensation plans can also benefit you by your own retirement income.

What is Deferred Compensation?

This is a business tool, typically financed with life insurance, that helps attract and retain quality employees with an unsecured promise to pay future compensation, generally beginning at retirement, as a reward for ongoing service. The catch: If they leave, they forfeit the benefit. This is why deferred compensation is often referred to as "golden handcuffs."

Who Needs Deferred Compensation?

You may if (A) you have a higher-paid employee in the top income tax bracket; (B) this person would prefer, for tax purposes, to defer a raise or current income to the future, such as retirement; and (C), as a business owner, you want to achieve certain objectives, which may include:

1. Enhancing your offer when recruiting quality employees.
2. Providing the financial incentive to motivate an employee to remain with the company.
3. Providing a special benefit for select employees.
4. Helping upper-income employees reduce their current income tax liability by deferring income into the future.
5. Reducing your own personal taxes and supplementing your own retirement income, since you can arrange deferred compensation for yourself.

How Does It Work?

In exchange for a future payment, the designated employee agrees, for example, to a salary reduction or deferral of a raise and the business agrees to make a specified number of payments, starting at a designated time, such as retirement. When the payments are made in the future, benefits are deductible by the company and taxable as income to the employee. Since this plan is not a qualified plan, the employee has flexibility as to when deferred compensation payments begin, as the funds are not subject to the minimum distribution rules that govern qualified plans.

Additionally, the business agrees to continue making the payments if the employee dies or becomes disabled. Many companies purchase life insurance (that accumulates cash value) and disability income insurance on the employee to help fund obligations. This helps assure that, whatever happens in the future, the money will be there to meet the company's obligation.

 
An Example of a Working Scenario

Veronica has been a tireless and dedicated employee. Jay, the owner, recognizes her value and has no intention of losing her. The deferred compensation package to follow was incentive for Betty to remain at the company.

The deferred compensation plan they agreed upon allows Betty to freeze her salary (a tax-saving strategy she enjoys) in exchange for $5,000 a month, beginning at age 65, payable for 15 years. The company purchases a $1 million life insurance policy on Veronica’s life. If she dies prior to retirement, her family receives the death benefit; if she lives, the cash value that accumulates in the policy can help pay the agreed upon deferred compensation.

Note: There are potential pitfalls and tax consequences. So, the agreement must be in writing, drafted by an attorney, and should spell out all conditions and provisions.

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Content is for informational purposes only and may not accurately reflect your specific situation. Information is not intended to provide legal, tax, or accounting advice. You should consult a qualified advisor for advice specific to your own circumstances.