A BASIC BLUEPRINT
Here's how a nonqualified plan might work. You perform your work exceptionally well, so you're in the line for a $10,000 raise. Your boss suggests that you defer $5,000 of your raise rather than receive it all currently. You agree, and so your salary increases from $50,000 to $55,000 rather than $60,000.
Observation: The agreement to defer income must be entered into before the deferred amounts are earned, in order to qualify for the tax deferral.
You don't pay tax on the $5,000 that you defer. Moreover, each year, your employer credits your account with, 10% in earnings. After one year, your account grows from $5,000 to $5,500 and you still owe no income tax. You will owe that tax only when the amount is paid to you, typically when you retire, leave the company or if you become disabled. When you receive the money and pay the income tax, your employer will get a matching tax deduction.
There is a downside, of course. What if your employer reneges on his promise or goes bankrupt before it's time to collect? In either case, you'd be out of luck because when you agree to defer compensation via a nonqualified plan, you become an unsecured creditor of your employer. (If you had a secured interest, you would have "constructive receipt" of the funds and owe income tax immediately.)
Observation: That's less of a problem with a qualified plan because the money must go into a trust, for which the trustees have a fiduciary responsibility. A nonqualified plan may be nothing more than a promise.
Several efforts have been made to secure nonqualified plans. In 1980 a Baltimore synagogue established an irrevocable trust to hold nonqualified funds for its rabbi, and the term "rabbi trust" came into the world. Rabbi trusts don't provide absolute security because corporate creditors can invade the trust in case a bankruptcy. But they do provide psychological comfort.
After years of uncertainty, the IRS has issued formal rules on rabbi trusts. Employers can establish rabbi trusts by those rules and feel confident that the money will be tax-deferred until withdrawal. In Revenue Procedure 92-64, the IRS provided a model rabbi trust for employers to use. It then spelled out, in Revenue Procedure 92-65, the guidelines under which a deferred compensation plan will hold up:
Participants must elect to defer compensation within 30 days after becoming eligible, or after the plan is adopted.
The plan must define the trigger events and the method of payout.
The plan may provide for payment in case of emergencies.
Participants must be general, unsecured creditors.
Participants cannot assign trust assets to their creditors.
SAFETY FIRST: SECULAR TRUSTS
What if you want a guarantee against bankruptcy as well? Then a secular trust (no religious connotations intended) can be used. With a secular trust, contributions are treated as current compensation taxable to you and deductible for your employer. The money in the trust essentially belongs to you, so it is out of the reach of corporate raiders and creditors should the company be acquired or go into bankruptcy. Taxes on contributions and earnings are due each year but not when money is withdrawn.
Observation: Tax professionals had worried that the earnings of secular trusts could be taxed twice: while they build up in the trust and again when they were withdrawn. But a 1992 private letter ruling (IRS LR 9212024) eased those fears. Although letter rulings can't be relied upon except by the taxpayers who requested them, they do demonstrate the IRS' thinking on a particular issue.
Secular trusts generally set restrictions on when you can withdraw your money. They may even contain golden handcuff provisions that tie you to the company. Why would you direct part of your compensation to a trust with strings attached, when you could simply take the money and invest it? In most cases, to gain supplemental employer contributions. You will have to pay tax on them, but they represent money you'd otherwise not receive.
While you can't avoid paying tax on contributions to the trust, you can avoid them on your trust earnings if the contributions are used to buy permanent life insurance. If you choose this strategy, you can access your funds at retirement via tax-free withdrawals and policy loans. In the meantime, thanks to the life insurance, your beneficiaries are protected against your untimely death.
Some tax practitioners recommend that companies set up secular trusts with a "Crummey power," a window of time in which the employee can withdraw money each year. Granting this power (even if it's not exercised) establishes the employee as the owner of the trust, these tax advisers say, so it is an extra safeguard in putting the assets beyond the reach of corporate creditors.
ANNUITIES: THE WAITING GAME
Even if your employer doesn't offer a nonqualified retirement plan, you can establish your own. If you purchase a deferred annuity, you will have tax-deferred buildup but not an upfront deduction.
An annuity is a contract between two parties. Jim gives Joan money or some other asset; Joan promises to make regular payments in return, generally for Jim's lifetime. You can purchase an annuity from many financial institutions, especially insurance companies. The basic annuity is an "immediate annuity". Suppose you come into a chunk of money, from a house sale, an inheritance or a lump-sum retirement plan distribution. You turn the money over to the insurance company and begin collecting income right away, usually each month.
An immediate annuity is a pure annuity , but that's not what the broker means when he calls to tell you about a sexy new tax shelter. Instead, he'll be touting a "deferred annuity." In this case, you give money to an insurance company now, but payments don't start until later. In the interim, any investment income is untaxed - that's the tax shelter.
There's a simple way to find out whether you're a good candidate for a deferred annuity. Ask yourself: Am I likely to have all the income I'll need in retirement through my retirement plan, Social Security and other assets? If the answer is yes, and you can reasonably expect to have all the spending money you'll need, don't buy a deferred annuity. You will merely wind up enriching an insurance company and saddling your heirs with more taxes when you die.
But suppose you can't put enough money into your current retirement plan. Or you don't participate in a formal plan. In these situations, when you want to supplement your retirement income, a deferred annuity may make sense. There's minimal paperwork, no rules to comply with and virtually no limits on the amount you can contribute.
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NONQUALIFIED RETIREMENT PLAN
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