Funding Your Future.

To leverage deferred compensation options, you have to do the math.

Finding and retaining top management talent is a daunting task, especially with unemployment at an all-time low. Nonprofit organizations have been at a particular disadvantage because, traditionally, compensation has tended to be lower than in the for-profit sector. Moreover, the nonprofit employer cannot entice the best talent by simply offering stock options and profit-sharing opportunities that can add significant value to portfolios anti sometimes even make executives multimillionaires overnight.

On the other hand, ASAE's 1999 Blue Chip Executive Compensation and Benefits Study (see "Rewards on the Rise" in ASSOCIATION MANAGEMENT'S February 2000 issue for an overview of the study) indicates that an increasing number of CEOs are beginning to reach the higher pay levels that compensate for the burgeoning responsibilities and increased stress that they share with their corporate counterparts. Deferred compensation programs for top management are becoming more common, easing the pain of the lack of lucrative private sector possibilities while helping to reduce taxes and accumulate retirement resources.

Factors influencing your deferral 

For the executive, the primary benefit of deferred compensation (as opposed to current cash compensation) is tax deferral. Deferring taxes is always beneficial to an employee. However, the effect of tax rates and the time value of money need to be taken into account. If the tax is deferred but then paid at a higher rate (which might occur, for example, if the funds must be taken out in a lump sum), some--but not necessarily all--of the advantage of deferral is lost. But because of the time value of money, rates must rise considerably to offset the advantage of deferring the tax payment. Obviously, the value of a tax deferral is lower if you're in the 28 percent tax bracket than if you're in the 40 percent bracket. As personal tax rates rise, so does the value of a deferral. Likewise, as the rate of return or the length of the deferral period increases, so does the value of the deferral.

Some may argue that you are better off taking compensation currently, paying tax on it, and investing the balance on your own rather than risking being a general creditor (based on the fact that you must trust in the organization's ability to pay) of the employer. It may also be argued that the political risk driven by a board's tendency to seek new management every few years might also tend to discourage deferral. Even if these risks were real, you would need to be disciplined enough to make systematic savings investments and then never withdraw any of the funds until retirement.

The value of tax-deferred compensation depends on three factors.

1. Incomes tax rates. The higher the tax rate during the deferral period, the greater the value of the set-aside account, which is essentially an interest-free loan from the government.

2. Deferral period. The longer taxes are deferred, the greater the value of the set-aside account because your money has more time to work for you.

3. Rate of return. The higher the rate of return on the investments that your employer (with your input) has selected for your funds, the greater the value of the credits to the set-aside account.

Think of these factors as the components of a matrix, each influencing the ultimate value of your account. If your current tax rate, deferral period, and rate of return are high, the value of your deferred account should be high. If more factors fall in the low categories, the value of deferral diminishes.

If you think your income tax rate at retirement (or time of distribution) will be less than your current tax rate, then deferral will almost always make sense. However, will deferral still make sense if your tax rate at retirement is projected to be the same as, or even higher than, your current tax rate?

Example. Let's assume that you're a 50-year-old association executive whose board has just authorized a $25,000 annual increase in your compensation. Your current marginal tax rate (the rate at which your next dollar of salary is taxed) is 40 percent, and you project the same 40 percent rate at retirement. Fortunately, you don't need the extra cash to live on, so you would like to know if it makes sense to defer the $25,000 until age 65, at which time you will receive a taxable lump-sum payment.

Result. Chart A shows the difference in the relative growth of a tax-deferred versus a taxable investment, with both invested at a 10 percent pretax rate of return. After paying the 40 percent tax on the current compensation, the earnings on the taxable investment provide a return of only 6 percent because every year you must also pay 40 percent of your investment earnings in taxes, reducing your return and limiting the growth of your investment to only $370,088 after 15 years. Looking at the tax-deferred investment, you can see that your money grows to $873,743. However, you now have a tax bite of $349,497 at retirement. Still, after paying your taxes, you have $524,426--or $154,158 more than if you had paid taxes each year as you received the $25,000. This number would be different if you could increase your taxable reinvestment rate by purchasing, for example, a tax-deferred annuity, tax-efficient mutual fund, or an appreciating growth stock. But you would still need to do the math to see if your net retu rn is better taking the current dollars or deferring them.

Now let's take a look at what happens when you expect your marginal tax rate at retirement to be higher than your current marginal tax rate.

Example. Suppose your current marginal tax rate is 33.8 percent, but you think you'll be in a 40 percent tax bracket when you retire. You have the option of deferring $25,000 under a nonqualified plan (see sidebar, "Qualified Versus Nonqualified Plans") or having the money paid out and taxed currently. You think you can earn a 10 percent pre-tax return.

Result. Surprisingly, you would be better off not taking the $25,000 as current compensation if the deferral period is longer than five years. But if the deferral period is fewer than five years, then you would be better off taking an immediate payout. Chart B shows the comparable current tax rate and deferral period required to match the same after-tax investment. Assuming the 40 percent tax rate at retirement and a constant pre-tax rate of return of 10 percent, a current tax rate exceeding 33.8 percent favors a 5-year deferral, a current rate exceeding 29.2 percent favors a 10-year deferral, and a rate exceeding 25.2 percent favors a 15-year deferral. Note that the deferral period has an inverse relationship to the tax rates. A lower current tax rate generally requires a longer deferral period to receive a comparable return.

Looking at the numbers you would probably decide, in most cases, to defer the money. But before you do, you need to understand the tax requirements of the different plan alternatives.

Relevant tax principles

The tax treatment of deferred compensation can be confusing because Section 457 of the Internal Revenue Code treats plans established by tax-exempt employers more restrictively than those of taxable employers. Hence, tax-exempt organizations and their key employees must work through Section 457 of the Internal Revenue Code to understand how various options are treated.

Section 457 rules apply whether the employee makes the deferral through salary reduction or the employer initiates the deferral. The section covers two types of plans: the eligible 457(b) plan and the ineligible 457(f) plan. As an executive of a tax-exempt employer, your deferred compensation will fit into one of those two broad categories (each with its own tax implications) or will fall outside of the reach of the section altogether.

You will need to understand, then, the differences between the eligible and ineligible Section 457 plans, as well as the those plans that fall outside of the harsh provisions of Section 457. While eligible plans tend to pose less risk, the plans that fall outside the purview of Section 457 (b) allow the largest potential income accrual.

* The eligible Section 457(b) plan.

The eligible plan allows for more generous treatment than ineligible plans and is not subject to the guidelines governing substantial risk of forfeiture. In some ways, the eligible plan looks like a qualified plan in that there is an annual contribution limit, vesting, transfers, and specific distribution rules. Unlike a qualified plan, however, unfunded benefits are provided only to a specific employee group--usually top management--with a maximum annual deferral of $8,000. The employee vests immediately in the deferrals, which must be distributed upon retirement, death, disability, termination of employment, or due to an unforeseeable financial hardship. Employee deferrals into an eligible 457(b) plan and other plans such as a 401 (k), 403(b), or Simplified Employee Pension are combined for purposes of the annual $8,000 limit. Thus, if you are deferring $8,000 into a 401(k) or 403(b) plan, you cannot defer anything more into an eligible Section 457(b) plan.

In practical terms, coordination of Section 457(b) deferrals with deferrals under any of the foregoing plans limits the availability of certain nonqualified arrangements for employees of tax-exempt organizations.

* Ineligible Section 457(f) plans. An exception to the $8,000 maximum annual deferral occurs when a plan contains a substantial risk of forfeiture provision, in which case deferrals are unlimited. To enable higher benefits or to condition benefits on the future performance of services, or both, employers may add a provision to the agreement that puts the executive's benefits at risk. This arrangement is usually referred to as a golden handcuff plan (see the "Legal" column, "End-of-Employment Severance Agreements," in the March 2000 issue of ASSOCIATION MANAGEMENT).

Compensation is subject to a substantial risk of forfeiture if the right to receive it is conditioned upon

1. the future performance of substantial services;

2. refraining from performance of substantial services; or

3. subject to the occurrence of a condition related to the purpose of the transfer.

In addition to one of these three requirements, the possibility of forfeiture must be substantial if the condition is not satisfied. This means that tax deferral can continue so long as there is no vesting, which occurs only when the risk of forfeiture lapses.

The IRS is taking a closer look at forfeiture provisions to determine whether a risk is substantial. See Table 2 for some illustrations of what might be considered substantial risks of forfeiture.

If a substantial risk of forfeiture is not present, the employee is taxed immediately on the amount of the deferral, even if the funds are not otherwise available to the employee. That is, the employee would be taxed whether he or she could have reached the money or not. Here's how this often-overlooked principle works.

Example. You are 55 years old and your nonqualified plan states that your nonprofit employer will set aside $25,000 per year for the next 10 years until you retire at age 65. However; if you quit before age 65, you will forfeit all of the deferrals plus earnings thereon. The plan further provides that at age 65 you will receive the set-aside in five equal annual installments.

Result. The present value of those payments is taxable at age 65 even though your payout in that year is equal to only one fifth of the balance of the set-aside.

Reasoning. Your account is no longer subject to a substantial risk of forfeiture. Unlike many plans established by taxable employers and those included in Section 457(b), where the employee is taxed under the provision of constructive receipt when the funds are paid or otherwise made available, ineligible Section 457(f) plan recipients are taxed when the risk of forfeiture lapses. In this example that would be at age 65.

* Plans falling outside of Section 457. To achieve your financial objectives and those of your employer, you may want to consider one or more of a number of other arrangements that fall outside of the reach of Section 457--while avoiding some of the section's restrictions and complexities. Here are some of the more common arrangements.

1. Fringe benefit plans. Plans providing for bona fide vacation, leave, severance, disability, or death benefits are not treated as plans providing for a deferral of compensation, and accordingly, are not covered under Section 457. Severance plans in particular offer interesting planning opportunities. If a plan provides that upon termination of service for any reason you are entitled to a certain multiple of base compensation (e.g., one year of base compensation), it would appear that such a plan does not fall within 457. The IRS will look to ensure that the plan is bona fide and not a mere device to provide deferred compensation. Hence it is wise not to abuse this option, as the tax consequence of an adverse IRS determination could be severe.

2. Option to buy marketable securities. Options fall outside of Section 457, and there are a number of such plans being promoted. Here is one illustration of how options work.

Facts. On January 1, 2001 (the grant date) your employer gives you an option (in exchange for reductions in future salary) to purchase, on or after January 1, 2004 (the exercise date), 10,000 shares of a mutual fund at 50 percent of the fair market value (the exercise price) on January 1, 2001. Assuming the fair market value of the mutual fund is $100,000 on the grant date, the exercise price would be $50,000. On January 1, 2004, the value of the mutual fund is $150,000 and you exercise the option.

Result: You pay no tax on January 1, 2001 (the grant date). You have ordinary taxable income of $100,000 on January 1, 2004, measured by the excess of the mutual fund's fair market value of $150,000 on January 1, 2004 (the exercise date) over $50,000 (the exercise price). You will pay taxes on the $100,000 at your regular income tax rates.

Reasoning. This particular option is designed to be taxable only when it is exercised. Hence, there is no tax consequence on January 1, 2001 (the grant date). Moreover, if the value of the mutual fund falls below $50,000, you may never even exercise the option. In addition, because the exercise date can be extended beyond January 1, 2004, taxation could be deferred until the option is exercised at some future date. Because options fall outside of Section 457(f), the executive could become effectively vested for the sum of $100,000 without paying taxes when the substantial risk of forfeiture lapses on January 1, 2004. As with many new and creative plans, the IRS is looking at this one, but they have not yet challenged it.

3. Split-dollar insurance plans. Equity split-dollar insurance is one of the more traditional arrangements used for providing a death benefit for the executive's beneficiary and his or her employer. The insurance contract also contains an investment feature. These multiple features make such plans highly attractive for many executives and their employers. This attractive approach combines a split-dollar life insurance plan with the deferred compensation plan, using a single policy to finance both plans. The policy may be owned either by the employer under the endorsement method or by the employee under the collateral assignment method.

The endorsement method. As the policy owner, the employer controls the cash values and is responsible for the premiums. At retirement, the split-dollar plan is terminated. The employer retains the full value of the policy's cash value and uses it to finance the benefits under the nonqualified deferred compensation plan. This is done either by currently making use of the cash value to pay retirement benefits, or by paying retirement benefits out of current assets and holding the policy until the employee dies, thus receiving the death benefit proceeds as cost recovery.

The collateral assignment method. The employee owns the policy and names a beneficiary. Typically, the employer purchases the policy on the life of the employee and pays 100 percent of the premiums. The employer will have an interest in the cash value and a portion of the death benefit as collateral only to the extent of the premiums paid. The terms of the employer's interest in the policy are spelled out in a collateral assignment form, If the executive dies while the collateral assignment is in effect, the employer recovers premiums from the death benefit. The remainder goes to the insured's personal beneficiary.

Tax consequences. Under either ownership method, the executive pays minimal taxes on the cost of the pure term insurance element. In return for this small ongoing tax cost, however, if the executive dies before retirement, his beneficiary's share of the death benefit is received income-tax free. If the employer relinquishes its interest in the policy, the cash value is taxable to the executive because the employee now receives an asset to which he or she has no prior right or title.

When the employee owns a policy under the collateral assignment method, a principle in the insurance industry usually applies: The inside buildup of a policy's cash surrender value is not taxable to the employee.

The IRS has followed this principle until recently when it ruled to the contrary, a development that has led to the creation of some new and highly creative split-dollar plans.

4. TARGET Plan. One particularly intriguing form of deferred compensation arrangement is the TARGET Plan (Tax Advantaged Retirement-GREIT's Exempt Trust). Funded by cash-value variable, universal, or whole life insurance, the plan offers the potential for significant tax savings by choosing certain permissible tax elections in the Internal Revenue Code.

The TARGET Plan is designed to be applied to a new or an existing deferred compensation plan and can be designed to be revenue neutral to the organization, that is, the nonprofit organization receives back in the form of a death benefit all the premiums they've paid. The accrued benefit to the employee, measured by the policy's cash value, can be safeguarded from claims of corporate creditors and, as early as five years from inception, can be accessed by the employee income-tax free. Unlike most nonqualified deferred compensation plans, there is no immediate taxation at the time that risk of forfeiture terminates.

However, the TARGET Plan, though well constructed from a tax perspective, has yet to be tested by the IRS.

Putting the pieces together

Executives of nonprofit organizations are at a distinct disadvantage when it comes to compensation packages. They have a genuine need for additional savings for retirement and other purposes. Nonqualified deferred compensation plans are best for meeting those needs.

Your particular deferred compensation arrangement should blend in with your overall personal financial plan. The deferral features and assets used to provide benefits must take into account your income and estate tax situation, as well as your insurance needs. Remember: Your plan needs be tailored to meet your specific needs.

Charles F. Tate is a certified public accountant and a certified financial planner. He is the managing partner of Tate & Tryon, CPAs and Consultants. Washington, D.C., and its affiliate, Tate Financial, LLP 

              EFFECT OF INCOME TAX RATES ON INVESTMENT RETURN
Deferral Period Retirement Rate Current Rate
5                    40.0%         33.8%
10                   40.0%         29.2%
15                   40.0%         25.2%
                TERMINOLOGY FOR NONQUALIFIED AND QUALIFIED
                    DEFERRED COMPENSATION ARRANGEMENTS
After-tax rate of return        Return on an investment after paying
                                the tax.
Benefit equalization            Provides benefits in excess of
                                qualified plan limits.
Benefit replacement             Supplements benefits lost when the
                                executive changes employers.
CODA 401(k)                     Cash or deferred
                                arrangements--qualified plan deferrals
                                that
                                are combined with 457(b) deferrals for
                                $8,000 limitation.
Constructive receipt doctrine   Taxes income when it is made
                                available, even if not
                                actually received.
Effective tax rate              Rate at which taxes are paid on total
                                taxable income.
Excess benefit                  Provides benefits in excess of
                                qualified plan limits.
Excise taxes on excess benefits Taxes imposed on excessive benefits
                                paid by 501(c)(3) and (c)4s.
Golden handcuffs                Retention tool with forfeiture
                                provisions if the executive leaves.
Grandfather 457 plan            Generally refers to deferrals pursuant
                                to a written agreement
                                in effect on or before August 16,
                                1986, such that the $8,000
                                limit of Section 457(b) does not
                                apply.
Investment account              Investment used for the hypothetical
                                account that earns a fixed
                                or variable rate of return.
Marginal tax rate               Rate at which the next dollar of
                                income is taxed.
Parachute                       Provides benefits when a change of
                                control occurs.
Performance incentives          Provide benefits only if certain
                                performance objectives are met.
Qualified plan supplement       Provides benefits in excess of
                                qualified plan limits.
Rabbi trust                     Holds assets of the nonqualified plan
                                to provide added security
                                while retaining an unfunded status.
Salary continuation             Specific benefit amount or percentage
                                of compensation at
                                retirement.
Salary reduction                Reduced compensation and earnings
                                thereon credited to a
                                hypothetical account.
SEP                             Simplified employee pension--qualified
                                plan deferrals that are
                                combined with 457(b) deferrals for
                                $8,000 limitation.
Substantial risk of forfeiture  Rights to property transferred are
                                conditional and subject to
                                substantial risk forfeiture if the
                                condition is not met.
TSA (403(b))                    Tax-sheltered annuity--qualified plan
                                for 501 (c)(3) deferrals
                                that are combined with 457(b)
                                deferrals for $8,000 limitation.
Unfunded plan                   Benefits are paid solely from the
                                general assets of the employer.
401(k) overlay plan             Provides benefits in excess of
                                qualified plan limits.
                      SUBSTANTIAL RISK OF FORFEITURE?
Forfeiture provision                    Likely Unlikely Reasoning
Employee can be discharged for                    *     Questionable risk of
cause or for committing a crime.                        forfeiture
Employee leaves before rendering          *             Substantial services
three years of service.
Employee stays for three years                    *     Unilateral and
but voluntarily extends (rolls)                         questionable risk of
the deferral period for another                         forfeiture
three years.
Employee stays for three years            *             Not unilateral and
but employer and employee negotiate                     possible risk of
an extension that (rolls) the deferral                  forfeiture
period for another three years.
Employee leaves before rendering                  *     Services not
two years of service.                                   substantial
Employee receives a bonus if              *             Substantial risk of
revenue increases by 10 percent per                     forfeiture
year, but forfeits it if after
5 years reserves do not grow by
50 percent during the 5-year period.
Employee (age 64 and terminally ill)              *     Unlikely risk of
must not work in the employer's                         forfeiture
industry (technology) for 18 months
following separation.
Employee (age 46, attorney, engineer,     *             Substantial risk of
and former congressman) must not work                   forfeiture
in the employer's industry (technology)
for 5 years following separation.
Employee, a doctor, must review                   *     Services probably not
cases and consult to the hospital                       substantial
following the completion of employment,
quantity of services not specified
(probably minimal.)

Qualified Versus Nonqualified Plans

Deferred compensation plans can have many features. Some provide for an additional employer contribution or future benefit, while others do little more than allow for elective deferrals from the employee's present salary (deductions that are transferred to an account that will not be taxed until a future time). It pays not only to understand your employer's current plans, but to be aware of the other types of arrangements that you might negotiate with your employer as part of a complete package.

Basic differences

Many organizations offer qualified retirement plans (plans that qualify for tax treatment designated under specific sections of the tax code) to all employees who meet certain basic eligibility requirements. The more common qualified plans are the defined contribution pension, profit sharing, 401(k) plans and--in the case of 501(c)(3) organizations--the 403(b) plan. Under most of these plans, the employer makes a contribution for each eligible employee, usually expressed as a percentage of compensation.

Annual employer contributions to defined contribution plans are limited to $30,000, although only the most generous plans allow the executive to actually reach this limit. Elective deferrals or employee salary reductions in the case of a 401(k) or 403(b) plan are generally limited to $10,500 per year.

A non qualified deferred compensation plan is a plan by which an employer provides deferral of income until a future time--such as retirement, death, or disability--for one or more selected employees. The plans do not meet the general requirements for qualified plans and, thus, the taxation for such plans is specified by another set of IRS regulations. For the employees, these plans provide supplemental benefits through deferral of taxes, increased retirement savings, and other means. They have an additional advantage in that some of the options may allow participants to accumulate far more in the way of tax-deferred funds than qualified plans do. For example, the typical qualified 401(k) plan puts an annual cap of $10,500 on the amount of elective salary deferrals that can be placed in the plan, while some nonqualified deferred compensation options allow for almost unlimited deferrals.

Under many nonqualified plans, benefits and payment terms can be tailored to the needs of the employer and employee. The arrangement can be structured to provide a specific employer contribution salary or bonus deferral, or a specific retirement benefit.

Because nonqualified plans are so flexible, advisers tend to use an assortment of distinctive names to identify specific types of deferred compensation arrangements or SERPs (Supplemental Executive Retirement Plans). See Table 1 for a list of commonly used terms.

Regardless of what label a plan bears, you need to remember that all plans have one common objective--to defer taxation into the future.

Risks and tax rules

In a qualified plan, employer contributions and earnings thereon are owned by the plan and are maintained for the exclusive benefit of its participants. Nonqualified deferred compensation benefits rest on the employer's contractual promise to pay and for that reason can have substantial risk attached to them, if, for example, the organization should file bankruptcy. Unlike qualified plans, assets are not set aside for the exclusive benefit of the employee. The employer does not relinquish ownership in any assets until they are paid out to the employee.

The critical tax factor in a nonqualified arrangement is based on the caveat that no employer assets may be set aside for the exclusive benefit of the participant. If the employee can control that asset as though he or she owned it, then the tax rules treat the employee as the effective owner. When this occurs, the plan is considered funded--and the employee is taxed immediately (under the tax doctrine of constructive receipt) as if he or she were in receipt of the asset.

Funding options

The term funding often gives rise to confusion when discussing deferred compensation plans, particularly nonqualified plans. As mentioned above, qualified plans are funded by employer contributions and/or salary reductions authorized by eligible employees. Employer and employee contributions are set aside in trust for the exclusive benefit of the employees.

In the case of nonqualified deferred compensation plans, a plan can be informally financed with employer-owned investments, life insurance, or other assets that provide a substantial measure of payment security for the executive but remain available to the employer's general creditors--and that are not for the exclusive benefit of the participant. Finally, the plan is not necessarily considered to be funded merely because the executive may choose among various investment modes.

Protections

Nonprofit organizations by their very nature have a proclivity for frequent changes in management and, particularly, in the board. Even in situations where the board has the best of intentions, the organization may simply be financially unable to pay benefits when they come due. Therefore, you should prefer a plan in which assets are set aside in some manner to make them available to pay benefits. Although formally funding a nonqualified plan is impossible from a tax standpoint, the arrangement can provide any degree of security the employer and employee agree upon, so long as it does not create a funded plan.

Possibly the simplest approach to plan financing is for the employer to establish and maintain an earmarked investment reserve account into which contributions are received and invested. The amount to be deposited in the account can be negotiated between the employer and employee, but generally the employer reserves discretion as to the amount actually contributed to the reserve account. The account does not act as a trust, although one could be established (see "Rabbi Trust" in Table 1). Assets in the account are, at all times, fully accessible to both the employer and its creditors. If the employer wishes, the reserve account can provide for limited employee investment direction. The employee is given advisory rights in recommending investments, but the employer makes the ultimate investment decisions.