Pension and profit sharing plans are a means to set aside funds for retirement.
Congress has provided tax benefits to qualified pension and profit sharing plans
in an effort to encourage employers to provide retirement benefits to employees
and to encourage the self-employed to save for their own retirement.
Because qualified plans must meet strict requirements, they may prove too burdensome
for some employers. Many employers are looking for alternative ways to provide
retirement benefits for themselves and key employees that will come close to
the benefits of qualified plans.
One alternative is life insurance. Life insurance can have some of the same
general benefits as qualified plans. To understand why, you need to know not
only the differences between qualified and nonqualified plans, but also some
of the tax characteristics of a life insurance policy. First let’s discuss what
it means to be qualified.
Qualified for What?
One of the general principles of income taxation is that an employer can take
a deduction for wages paid only when the employee is required to report the
wages as income. Usually, this is when the wages are paid. Deferred compensation,
which generally includes retirement and pension payments, is compensation received
in a later year than when earned and currently is not deductible by the employer.
However, qualified deferred compensation provides two important benefits:
- The employer may deduct the compensation when it is, in fact, set
aside for the employee, but the employee does not report the compensation as
income until he or she actually receives it. This is one of the few areas where
the Internal Revenue Code (IRC) sanctions a mismatch of deduction and inclusion.
- The compensation that is set aside for the employee can earn and
accumulate income tax free until the employee receives it.
Qualified deferred compensation must be part of a plan and can take different
forms:
- Defined benefit plans. What employees receive at retirement is a
percentage of salary earned while they worked.
- Defined contribution plans. Employers put a certain dollar amount
into the plan and the kind of retirement benefit employees receive depends on
the investment performance of their accounts. Section 401(k) plans and IRA accounts
are forms of defined contribution plans.
All qualified plans require employers to put funds aside now so that employees
can get at them later.
Stringent and Formal Requirements
Most important, qualified plans cannot discriminate in favor of the highly
compensated. Also, the participating employee’s benefit must become nonforfeitable
(vested) within a short period of time (gradually from three to seven years
or all at once after five years -- shorter if the plan predominately benefits
the highly compensated). Further, the plan must benefit a large percentage of
the company’s employees.
For pension plans, there also are funding requirements. For example, employers
must do more than make a promise to pay; they must put the appropriate amount
into the plan each year. Recent legislation provides that, in considering whether
a plan favors the highly compensated, compensation in excess of $150,000 must
be ignored, thereby causing certain highly compensated individuals to receive
benefits based on a lesser percentage of their salaries than the rank and file
employees.
Why Avoid A Qualified Plan?
One of the reasons for looking for a substitute for retirement planning is
to avoid the requirements necessary to be qualified. Why? You may want a plan
solely for officers of the employer. By definition, a plan for officers will
favor the highly compensated. Such a plan also will fail to satisfy minimum
participation standards for a qualified plan because fewer than 70% of employees
participate in the plan.
Life Insurance Plan Advantages
If you want a retirement plan to benefit only highly compensated or stock-owning
employees, or others with a financial interest in the business, you have to
use a nonqualified plan. Life insurance has several tax advantages that make
providing retirement benefits desirable.
For instance, earnings in the insurance policy accumulate tax free. Also, the
owner of the policy (usually the insured) can borrow against the cash value
in the policy without tax consequences if the policy comes within the IRC definition
of life insurance. Generally, to fit the definition of life insurance, the policy
must have premiums scheduled over a period of at least seven years. The employee
must pay interest on the borrowed sum, and the interest rate often is close
to the dividend rate being earned by the cash values in the policy.
Having a policy with a premium pay-in period of seven or more years, by itself,
is not unusual and does not need an employer to implement it. The employee
may make seven or eight scheduled annual premium payments using funds from his
or her own pocket. Often, the source of the premium is an annual employer-paid
bonus that is deductible to the employer as compensation paid and taxable to
the employee as income. Depending on the type of insurance product being used
for the nonqualified plan, the scheduled premium payments can be tailored to
the employee’s current financial situation and future objectives.
If an employer wants to further benefit the employee, it can contribute unscheduled
premium payments (nondeductible), retaining the right to receive these payments
back without interest at a later date. In essence, the employer can agree to
a split-dollar insurance arrangement -- the employer is making a tax-free loan
to the employee’s policy.
The type of insurance policy used for a nonqualified plan often is a second-to-die
(husband and wife) whole-life product that is interest-sensitive and designed
for greater cash value accumulation. The nonqualified plan can continue for
as long as the employee desires.
A Few Important Life Insurance Questions
Q: What happens when the employee retires?
A: Up to a certain point, the employee borrows cash value from the policy
and never has to report the loan proceeds as taxable income. However, some
cash value must stay in the policy to support a death benefit.
Q: How good is the rate of return on insurance policies?
A: That depends on interest rates and the insurance company’s investment performance,
but the unscheduled premium payment from the employer should provide additional
accumulation for the employee. Your insurance advisor can provide an illustration
at various interest rates. Look at a minimum at the strength of the company,
the current rate the company is offering and its lowest guaranteed rate.
