A "non-qualified" deferred compensation plan might make more sense for your key employees.
Recruiting and retaining the best managers often require business owners to offer competitive, tax-advantaged compensation packages. Yet, the tax laws aren't always as sympathetic to that mission as we might like them to be.

Tax-qualified plans, the mainstay of retirement planning, just aren't intended to favor highly-paid executives. Pensions and 401(k) plans must benefit rank-and-file employees, too, and they're subject to strict caps on contributions. They're also burdened by onerous ERISA recordkeeping, reporting and compliance obligations.

A "non-qualified" deferred compensation plan might make more sense for your key employees. Such plans allow employers to select participants and design the benefits they'll receive without any statutory ceiling or ERISA mandates.

A non-qualified plan can mimic a 401(k), but without any IRS filings. Instead, the employer merely enters into a contract with the employee, permitting him or her to defer current pretax income in exchange for the employer's promise to pay retirement (or survivor) benefits later. The employee cuts his or her income taxes now and uses the deal as a tax shelter: everything the employer contributes and all the capital gains, interest and dividends it earns grows free of tax until the benefits are paid.

As appealing as they are, non-qualified plans are imperfect. Since they are unfunded, the employee runs the risk that the company may not deliver on its promise once payment day arrives. And, of course, the employer's tax deduction is deferred until payment is made. For some, this is in fact an advantage: to forego deducting the "acorn" and, instead, write off the "oak tree".

A couple of strategies are particularly popular in making the most of a non-qualified plan. The first involves structuring the plan to zero in on a 401(k)'s unique appeal. The employer can match the employee's deferred pay or a portion of it - but, again, only with promised dollars, not real ones. Then, the executive allocates his hypothetical "account balance" among different investment choices, letting him or her assume an investment risk to accrue greater retirement rewards. The executive is always fully vested in the salary he or she defers, but matching "contributions" vest according to an agreed schedule. When the executive retires, dies, becomes disabled or leaves the company, his or her vested account balance is paid out and the company takes its deduction.

It's wise to keep in mind that the participant's account is only a bookkeeping entry. As the investment grows, the company's liability is growing, too. So, the prudent employer will invest money elsewhere to pace hypothetical investment results and offset its eventual obligation. Here's where another strategy can profitably be put into action.

Mutual funds are among the most popular investment choices for 401(k) plans, but they don't work particularly well for "shadow" investments informally tied to non-qualified plans. The company which owns such mutual funds incurs a tax cost on the dividends and capital gains they declare.

A better choice for most employers is the purchase of a variable life insurance policy on the life of the executive. Variable life combines insurance coverage with an investment vehicle and can be structured to pay a benefit more or less when it's needed - whether at the employee's retirement or death. What's more, variable life avoids any current income tax on earnings or gains. Finally, it allows the executive to make investment choices consistent with his or her risk tolerance and time frame.

The employer who seeks to be competitive in compensating its executives might well entertain establishing a mirror 401(k) plan, but should seek knowledgeable counsel to design and coordinate its tax, contract and investment components.

About the Author

Marc Lane is a business and tax attorney, a Master Registered Financial Planner, a Registered Financial Consultant, and a Certified Investment Specialist. Marc is the author of 30 books on business organization, taxation, and personal finance. His newest book, "Advising Entrepreneurs: Dynamic Strategies for Financial Growth" draws from his experience working with those who have successfully built their businesses. Marc is an Adjunct Professor of Law at Northwestern University and an Adjunct Professor of Business at the University of Illinois. His practice areas include Individual Taxation, Corporate Tax Planning, Business Tax Planning, Estate Planning, Investments, Retirement Planning,Elder Law, International Trade, Business Law, and Wills, Trusts and Estates. Additional articles, case studies, and a free email newsletter are available at www.marcjlane.com.