Use Life Insurance and a Rabbi Trust To “Fund” Your Nonqualified Deferred Compensation Plan

Estate Planner Mar-Apr 1998

Companies use nonqualified deferred compensation plans to compensate key employees over and above the employees’ base salaries. Because employers cannot set aside money protected from creditors to fund nonqualified plans without incurring current tax liability for the employees, they often use life insurance and rabbi trusts as funding mechanisms to meet both the employees’ needs and their own.

How Nonqualified Plans Benefit Employers 

Nonqualified plans benefit employers by offering the employees an incentive to stay with the company over a period of years, often through a vesting mechanism. For example, a plan might provide that an employee will receive a certain amount of compensation on termination of employment, but that only a portion of that compensation will vest each year over the next 10 years. Thus, to receive the entire amount of deferred compensation, the employee must remain with the company for 10 years.

In addition, with a properly structured nonqualified plan, the company can avoid the highly complex and burdensome rules that cover qualified plans. These include rules on participation, coverage, discrimination and reporting.

How Nonqualified Plans Benefit Employees 

Nonqualified plans benefit key employees by allowing them to defer tax on compensation that they will receive in later years, when their effective tax rate may be lower. Under a typical nonqualified plan, amounts are deferred while the employee works for the company and are paid later when the employee retires, becomes disabled or dies. The goal is to structure the plan so that the employee is not taxed on those amounts until one of these events occurs and the employee is actually paid.

To ensure that the employee is not subject to current tax on the amounts payable under the nonqualified plan, the plan cannot be funded. This does not mean that a company cannot set aside funds to satisfy its future obligations. What it does mean is that any amounts a company sets aside to ultimately pay the deferred compensation must be subject to the claims of the company’s general creditors. Otherwise, the employee is treated as having received the compensation and is currently taxed on those amounts.

Life Insurance Provides Indirect Funding Mechanism

Life insurance is a popular funding mechanism for a nonqualified plan. Typically, an employer purchases insurance on the life of an employee. The company then owns the policy and also is named its beneficiary, but does not receive a deduction for premium payments on the policy. To avoid being taxed on the value of the contract, the employee generally does not receive any interest in the policy. The employee cannot name a beneficiary to receive life insurance proceeds on his or her death, but can name a beneficiary of the nonqualified plan, such as his or her spouse, to receive the then-vested amounts of deferred compensation.

Any insurance proceeds paid to a company on an employee’s death generally are on an income-tax-free basis, though they may be subject to alternative minimum tax. If the employee retires or becomes disabled and is entitled to amounts under the nonqualified plan, the company can relinquish the policy and use the cash value to pay the deferred compensation. This may, however, result in current taxable income to the company, but only to the extent of the gain.

The Rabbi Trust Offers Preservation and Protection

A rabbi trust is a type of nonqualified plan in which funds are segregated into an irrevocable trust. The trust helps preserve funds an employer might otherwise spend and offers an employee some measure of comfort that money will be available when the deferred amounts become payable to him or her.

More important from an employee’s perspective, a rabbi trust allows a company to irrevocably segregate funds that it can use to pay the compensation in the future. Although these funds are subject to the claims of the company’s general creditors, they remain in the trustee’s control if the company changes hands. Despite the fact that funds are segregated, the rabbi trust is not deemed to be a funded plan.

Life Insurance and Rabbi Trust in Tandem

A company can use life insurance in tandem with a rabbi trust by making contributions to the trust to fund the premiums. The trust then uses those funds to purchase insurance on the employee’s life. The trustee is both the owner and beneficiary of the policy.

To avoid current taxation, neither the employee nor his or her beneficiary can have an interest in the insurance or the trust assets. The employee (or his or her beneficiary) will only have rights to amounts held by the trust equal to those of an unsecured creditor. If the nonqualified plan meets these and certain other requirements, it will be considered unsecured and unfunded, and income tax to the employee will be deferred.

Benefits for Employer and Employee Alike

A nonqualified plan can effectively help an employer secure the continued services of a key employee. By purchasing life insurance through a rabbi trust, the company can enjoy a tax-advantaged investment vehicle while giving the employee some peace of mind that funds will be available to pay the deferred compensation. To learn more about these options, please call us. We can help you choose one that meets your needs.


Insurance Benefits for Companies With Nonqualified Plans

Used to fund a nonqualified plan, life insurance provides several benefits:

  • A company can receive a market rate of return on the investment in the policy while using it as a tax-deferred investment vehicle.
  • If an insured employee dies early in the term of the nonqualified plan, funds will be available to the company through the payment of the death benefit, which the company can then use to pay the employee’s beneficiary under the plan.
  • With a combination of loans and withdrawals against its cash value, the company can achieve tax-free distributions from the policy.