Implementing a Deferred Compensation Plan

Brett Ellen

Talk to any small- to mid-sized business owner and it's the same story. In today's recession-battered economy, they worry about asking their employees to work longer and harder, often for less money. Bonuses are not a possibility. Stock options have lose this allure. But what about a deferred compensation plan designed to motivate valued employees and attract top talent? Contrary to common opinion - with an advisor's help - it is possible to compete with the benefits offered at Fortune 500 companies.

Traditional deferred compensation plans offer employees the opportunity to defer taxes on current income, earn a rate of return on the money deferred, and withdraw from their account at some time in the future. Usually, a plan offers a menu of investment choices for those deferred dollars, including mutual funds, bonds, and company stock. A company also may decide to offer a match for employees who choose to invest in company stock.

Current market votality has many focusin on the potential downside of deferred comp plans. That is, worries over employee's deferred dollars being tied to the company's fortunes. If bankruptcy strikes, all that deferred compensation oculd disappear. What's more, if the future holds a hike in individual income tax rates, those dollars could be taxed at a higher rate upon withdrawal. However, I'd argue that in rare cases does a bankruptcy obliterate a deferred comp plan and that the potential tax deferred growth in employees' accounts over the long-term could more than offset the higher taxes. More importantly, a deferred compensation plan offers key employees great flexibility with how to invest to meet their unique financial goals, whether it's paying for college or saving for retirement. And from the business owner's perspective, adding a deferred compensation plan can help meet the needs of executive employees - without a significant investment from the employer. For example:

  • Help highly compensated executives save more tax-deferred. The 2009 401(k) contirbution limit is $16,500. If an employee reaches age 50 by December 31, 2009, they can contribute an additional $5,500, for a total contribution of $22,000. If an employee earns $65,000, that $22,000 is nearly one third of his earnings. FOr someone who earns $220,000, however, the 401(k) limit represents just 10% of their income, resulting in diminished opportunity to benefit frmo potential tax-deferred growth when compared to lower compensated employees. The percentages for highly compensated employees can be even lower in instances where a majority of lower compensated employees do not participate in 401(k) plan and what highly compensated employees can contribute to their 401(k) is reduced to keep the plan in compliance. You could argue that it's particularly unfair that highly compensated employees can contribute a lesser percentage of their earnings at a time when they, as corporate leaders, are being asked to work harder - and the market is on sales.
  • Grant executives greater flexibility with withdrawal. Under the current laws, if an employee takes distributions over ten years or longer, they are taxed in the state in which they currently reside. If, for example, they retire in Nevada and take a decade long distribution, they will pay no state taxes. (If and employee decides to withdraw money in less than 10 years, they'll be taxed in the state where they earned the money.) Also, with deferred compensation employees aren't required to wait until age 55 to tap into the account. Many participants choose to take distributions earlier to pay college bills. Along with federal and potentially state income taxes, these distributions may be subject to an additional 10% tax penalty, unless an exception applies. Individuals should discussj their personal situation with a tax advisor prior to taking distributions.
  • Provide an affordable way to offer a bonus. Because of the uncertain market environment, small businesses are implementing deferred compensation plans and offering company matches based on performance to motivate executives to work those extra hours each week. In addition to the benefit of tax-deferred growth, a side benefit to deferred compensation plans is FIICA withholding, so there is no FICCA due on the back end when an employee decides to take the money out.

Amazingly, although deferred compensation plans are a valued benefit for top executives, very few small or medium business owners have a deferred compensation plan in place. The stumbling block seems to be that the insurance companies and 401(k) providers offer the equivalent of "deferred compensation in a box" and may not customize their cookie-cutter plan to meet the specific needs of small business owners.

As a trusted advisor to small business owners, that's where you come in. Use the same financial planning process you successfully employ with individuals to help define your business owners' goals - and develop a strategy to motivate their employees to accomplish them. Tap into your strategic partnerships with life insurance companies to wrap the plan in corporate owned life insurance and mutual fund companies to provide investment alternatives. Business owners are anxious to discuss methods to help improve their bottom line. In addition to strengthening the relationship with your client by exploring ways to motivate their employees, helping with a relationship with your client by exploring ways to motivate their employees, helping with a deferred compensation plan can also open the doors to numerous highly compensated executives who themselves may need wealth management services. Talk about a triple strike.

Brett Ellen, founder and president of American Financial Network
Copyright 2009. All Rights Reserved.

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