Steve A Porter, CPA

By: Steve A Porter, CPA, CMA

If you have looked at retirement plans for you and your employees, it’s a sure bet that you are familiar with 401K plans. Chances are you already have one. Since they were introduced in the 80’s, there has been a literal explosion of these type plans.

Although they are very popular, they are heavily regulated by the DOL, and sometimes the rules as mandated by the government do not allow you the flexibility you want in rewarding your top performers. The problem usually arises when the plan becomes ‘top heavy’, ie: highly compensated employees receive a greater share of benefit than allowed by the regulations.

Fortunately there are other options available, and one of the most common involves ‘carving out’ highly compensated employees and allowing them to participate in a ‘non-qualified’ style plan.

Other Options: Non-Qualified Plans

A non-qualified plan can replace the existing plan, or exist alongside it. Employees can participate in both plans if the employer allows it. In reviewing what’s out there for these type plans, I found they have increased in popularity in recent years, and they also are very varied and come in many forms. Note that the general recommendation (not necessarily a requirement) is that 15% of the employees be in this plan. It is not meant to be a general retirement fund for all employees. It is a special plan for management and/or upper-tier executives.

The two broad categories are Supplemental Executive Retirement Plans (SERPS) and Non Qualified Deferred Compensation (NQDC).

SERPS are usually in the form of defined benefit plans where the employer foots the bill for a retirement/life insurance payout. NQDCs are contribution plans where employees defer a portion of their salary, and employers provide matching contributions.

Top Hat Plans is the common term for these NQDC style plans. They are very popular because they can be designed and set up to look and feel like (to the participant, at least) a 401K plan. However, there are no testing requirements, no non-discrimination rules, no fiduciary responsibility on administrators, no annual filing, no audits, and they are very flexible as far as pre-funding and payouts are concerned. Also, there are no limits on contributions. Most employers do set limits, but the limit is determined by the employer, not the government.

The structure of the plan is very different from a 401K plan, however. The plan is “unfunded.” This term is misleading because it does not mean the plan has no funds, only that the participant has no specific claim to the fund assets other than that of a general creditor. The assets in the funds are essentially arrangements made by the employer to finance the payout. There is no requirement for this financing (pre-funding), but that lack of financial security adds significant risk to participants. Administrative fees are very high if you do not provide financing for the payout.

Essentially, the participant has a legally binding contract with the employer that he/she will be paid “X” amount of money on a certain date depending on certain events. The payout can be tied to contributions made by employer and employee and/or fund earnings. You can even have a vesting schedule as long as the employee understands he/she does not own anything other than promise by the employer backed up by a contractual obligation. Note that this contract is not administered or regulated by the DOL as in the case of a 401K plan. It is simply a standard contractual obligation bound by standard contract law.

The assets of the fund are owned by the employer. As such, they are vulnerable if the company files bankruptcy. Also, any earnings on the funds are taxable to the company. That’s why most companies use Company Owned Life Insurance (COLIs) as the pre-funding asset. Of course mutual funds and similar investments can be used.

To give employees a little more security, most of these plans use a “Rabbi Trust.” which acts to set aside the fund assets in a special type of trust. These trusts offer no protection from involuntary liquidations such as bankruptcy, however. Also, Rabbi Trusts are required if participants make pre-tax deferrals.

Probably the biggest negative aspect of these type funds is that the employer does not get a tax deduction for contributions to the fund since the company retains ownership and control of the contributions. These tax savings over the years are VERY significant. Forfeiting that tax deduction is costly, however, you do get to deduct employer contributions it when they become taxable to the employee, usually through payout.

These type funds do provide a very good tax shelter for participants, however. And a C-Corp actually has a small advantage over pass though entities since any earnings on the plan are not passed directly to the owner.

If you are interested in these style plans, I would recommend getting proposals from several companies. The big players like Principal or Fidelity can help you learn about these type plans, and offer you quotes and advice on getting set up.

Although these plans have very relaxed rules and are very flexible, they are complicated financial arrangements, and there are several “gotchas” if not done correctly.

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