Unqualified deferred compensation plans can be funded with life insurance under certain circumstances. An unqualified deferred compensation plan is a binding contract between an employer and an employee in which the employer agrees to pay the employee at a later time. Specifically, the employer makes an unsecured promise to pay an employee’s future benefits, subject to the specific terms of the contract. These types of plans differ substantially from qualified plans, such as a 401 (k), which has stricter rules that investors must follow and usually has an income cap. Unqualified deferred compensation plans are not limited by income.
With unqualified deferred compensation plans, an employer can offer bonuses, wages, stock options, non-401 (k) retirement plans, and other types of compensation, without having to make immediate payments. By deferring the payment and providing it at a later date, the employer allows the employee to also defer the payment of taxes on this future compensation.
- An unqualified deferred compensation plan is a contract between an employee and their employer that says the employer will cover the cost of the employee’s benefits in the future, based on the terms of the contract.
- These plans are unfunded and have two parts: a contractual agreement between the employer and the contractor, and the employer’s general asset pool that covers future costs created by the plan.
- Two types of unqualified deferred compensation plans allow life insurance financing: Supplemental Executive Retirement Plans (SERP) and Corporate-Owned Life Insurance (COLI).
Funding of unqualified deferred compensation plans
Unqualified deferred compensation plans are unfunded plans that are divided into two parts. The first part is the plan itself, which is equivalent to the contractual agreement between the employer and the employee. The second part is the employer’s general asset reserve that funds future liabilities created by the plan. The general asset reserve is what the employer uses to pay the employee for future benefits.
The general asset reserve is required by generally accepted accounting principles (GAAP) and can be taxable assets such as mutual funds or employer-owned life insurance. The plan is the legal benefit between the plan participant (the employee) and the plan sponsor (the employer). The plan describes the general benefits, the distribution schedule, and the grant and forfeiture provisions.
Unqualified deferred compensation plans are often used by executives who want to defer income taxes on what they are earning.
Types of plans that allow life insurance financing
Unqualified deferred compensation plans can be financed with life insurance. There are two main funds that allow life insurance financing: Supplemental Executive Retirement Plans (SERP) and Business Owned Life Insurance (COLI). SERPs are similar to defined benefit pension plans and provide the employee with a set benefit provided by the employer upon retirement.
With corporate property life insurance (COLI), companies buy life insurance policies for the employees they want to compensate. The company pays the premium for life insurance policies and then pays benefits to employees when they retire.