Will Your Client’s Death Benefit Be Taxed? What to Know About NQDC Plans

Situation: Nonqualified Deferred Compensation (NQDC) plans are a flexible and strategic tool used by businesses to attract, retain, and reward key employees. Unlike qualified plans, NQDC arrangements are not subject to many of the strict contribution limits and nondiscrimination requirements imposed by ERISA. This allows employers to selectively offer enhanced retirement benefits to a targeted group of executives or highly compensated employees.

One common and effective method for informally funding these future obligations is through life insurance. However, there appears to be a great deal of confusion on how the death benefit paid to an executive’s beneficiary is taxed when a plan is informally funded with life insurance. Part of the confusion may stem from the fact that there is more than one way the benefit can be taxed depending on the structure of the arrangement. This Counselor’s Corner sheds light on the topic.

Solution: Before discussing how death benefit paid to an executive’s beneficiary in a nonqualified deferred compensation arrangement is taxed it might be helpful to have a high-level understanding of how life insurance typically works in such a plan.

1. The business and the executive enter into a contract. The executive agrees to defer compensation in exchange for pre- and postretirement benefits. Technically, the benefit is nothing more than an employer promise that does not need to be backed by any assets. However, many businesses elect to purchase life insurance to help offset the business liability created by the plan.
2. The business gives notice to the executive that insurance will be purchased on the executive’s life and receives consent from the executive.
3. The business purchases a life insurance policy on the executive’s life. The employer is the owner, premium payer, and beneficiary of the policy.
4. Employer contributions and premiums paid to purchase life insurance cannot be deducted for income tax purposes. With a properly structured nonqualified plan, the executive pays no current income tax on income deferred, on any additional employer contributions, or on earnings credited to the account until the benefits are actually or constructively received.
5. If the executive lives to retirement, the employer pays a retirement benefit that generally reflects the balance in the executive’s bookkeeping account. This payment is deductible by the employer and is taxable as compensation to the executive. Policy cash values may be accessed by the business to provide retirement benefits.3 Or, the employer can pay the benefit from current earnings and recover the cost of the plan at the executive’s death.
6. Alternatively, if the executive dies prior to retirement or before all payments have been received, many plans contain provisions that entitle the participant’s name beneficiary to receive a survivor benefit. In this situation the policy pays the death benefit to the employer and the employer pays any survivor benefit described in the agreement to the executive’s heirs.

It’s the payment of the benefit in step 6 that has caused some tax confusion, both from an income and estate tax perspective. I will first explore the structures that can create different income tax consequences for the beneficiary followed by the structures that result in different estate tax results.