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| The Basics | Work now, take your pay later
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This strategy isn't just for corporate bigwigs. Deferred compensation, despite its recent bad rap, can save you bundles in taxes.
By Jeff Schnepper
Deferred compensation has been getting a bad rap of late, and let's be careful about it. Most of us have a stake in the idea -- perhaps in ways we don't expect.
For much of the summer and fall, a number of corporate bigwigs were appropriately fried in the media when their deferred compensation packages became public. Perhaps best known was former GE Chairman Jack Welch. Details of his retirement package were revealed in divorce papers. Millions were paid to Welch; he was also given free use of GE apartments, offices, cars and corporate jets. (Welch agreed to reimburse GE for its costs -- estimated at $2 million a year.)
Welch's package is hardly unique, and companies have been able to deduct those expenses and others because they seem reasonable and appropriate. (That's the test, and, yes, it's easy.)
What gags us is the nature of the compensation -- really big -- and the ability to hide it from shareholders in financial statements. There've been calls to punish the devils by making certain forms of deferred compensation taxable. "There's a feeling on Capitol Hill of let's do something bad to executives,' '' says Catherine Creech, an estate-planning attorney at Davis & Harman in Washington, D.C.
Some legislation has been filed to curb some of the most outrageous deferred compensation plans. If more scandals erupt, you'll probably see more legislation filed.
Goal is a smaller tax bill today
So far, however, cooler heads have prevailed on any thought to doing wholesale curbs. Basically, all deferred compensation is nothing more than an arrangement for an employee to be paid certain benefits later in lieu of taking the cash now. You defer the payments because you might not need the dollars now, or you might be in a lower tax bracket when the benefits are paid.
In either case, the immediate advantage to you is a smaller current tax bill.
There are really two forms of deferred compensation: qualified and nonqualified.
Qualified deferred compensation represents dollars put aside under specific allowances provided in the Internal Revenue Code. The code lets you shelter real dollars now (a funded plan) that will be taxed to you later. Your employer gets an immediate deduction for the dollars put aside. These qualified plans include your traditional pension and profit-sharing plans, and your 401(k).
Everybody loves qualified deferred compensation. Now you see why we should be careful?
Nonqualified deferred compensation has been the target of most of the venom. In a non-qualified compensation plan, an employer promises to pay an employee in the future for services rendered currently. But these plans don't try to meet the stringent coverage and contribution requirements necessary to qualify for the special tax treatment granted qualified plans.
Because they don't "qualify," these plans are subject to other, less generous, tax rules. At the same time, since they don't "qualify," there are no rules as to who must be covered -- or how much can be contributed to the account. Your employer can discriminate, and the benefits of these plans can be limited to key individuals or groups or employees.
Nonqualified plans are becoming increasingly popular both for big corporations, small companies and for charitable organizations and colleges. Even churches and synagogues offer them. There's not a lot of hard data on how many plans exist, but there are literally thousands of Web sites devoted to the topic.
Organizations use them to attract and retain key executives and top performers, using benefits over and above what are allowed in qualified plans. They're usually cheaper to operate than a classic defined-benefit plan or even a 401(k) plan.
What drives people crazy about them is that they get to be so rich for some recipients. Jack Welch's deferred salary account is worth $38 million to $112 million, depending on which lawyers in his divorce case you talk to; his pension alone is $9 million a year, the New York Times reported recently.
With nonqualified deferred compensation, the employer only gets the deduction when you're taxed. When you're taxed depends on whether the arrangement is funded or unfunded.
Funded means you pay sooner
If the arrangement is funded, then you're taxed when your rights are transferable that is, you can sell them or give the assets away without condition. Or your rights are not subject to what's known as a substantial risk of forfeiture.
Your arrangement is considered "funded" if there's been a transfer of money into your name. A typical "substantial risk of forfeiture" would be your loss of all rights if you leave the company within a given number of years of service or prior to retirement. You wouldn't be subject to tax until those years are up, or you retired, potentially into a lower tax bracket.
If dollars are put in a trust for your benefit, and those assets can only be used to provide you future benefits, you're going to be taxed immediately.
Unfunded plans have more risk
But, if the benefits are payable from general business funds that are subject to the claims of your employer's creditors, the amounts are considered unsecured promises to pay money in the future and are treated as unfunded.
Unfunded arrangements are taxable to you only when the dollars are actually received or constructively received. Actually received means you took control of the money outright. Constructively means it was delivered to an account that you ultimately control.
Want to "secure" your unfunded arrangement?
The IRS has OK'd the use of an irrevocable trust that prohibits your employer from using the funds for purposes other than to provide nonqualified compensation. The only exception is that the assets must be subject to the claims of your employer's creditors in the case of insolvency or bankruptcy.
These trusts are called "Rabbi Trusts" because the IRS first validated them with respect to the deferred compensation of a rabbi. A bill currently before Congress, and sponsored by Rep. Robert Matsui, D- Calif., would make those dollars available to your employer's creditors prior to insolvency or bankruptcy (see link at left under Related Sites).
Unfunded deferred comp is a great idea under several scenarios:- If your employer doesn't want the limitations of a qualified plan and wants to give retirement benefits to only key employees.
- If your employer wants to give retirement benefits over and above those allowed with a qualified plan. You can have both a qualified and a nonqualified arrangement at the same time.
- If you, as an employee, want to defer the taxation from your peak earnings and maximum tax bracket years to lower bracketed retirement years.
- If you, as an employee, want a "forced" savings plan for your retirement years.
Deferred compensation is just one more arrow in your quiver of compensation benefits. It's nothing more than getting paid later for services rendered now. Let's not let our disgust at its misuse by corporate hogs cloud our understanding of the real benefits it can present when appropriately structured.
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