An excess benefit plan is a nonqualified deferred compensation (NQDC) plan that provides supplemental retirement income benefits to employees whose benefits under the employer’s qualified retirement plan are limited by the application of Internal Revenue Code (IRC) Section 415. Put more simply, the goal of the excess benefit plan is to allow employees who participate in a qualified plan to exceed the limitations imposed by Section 415. The benefit that is provided to an employee under an excess benefit plan generally amounts to the difference between what the employee would have received under the employer’s qualified retirement plan without applying the Section 415 limitations and what the employee actually receives under the qualified retirement plan.
IRC Section 415 provides limits on contributions and benefits under qualified retirement plans. Section 415 generally limits annual contributions made (by both the employer and the employee) under a defined contribution plan to the lesser of $56,000 or 100% of the participant’s compensation in 2019. In 2018, the limit was $55,000 or 100% of compensation. Employees age 50 or older can defer up to $6,000 to a 401(k) plan in excess of the limit for both years.
As for defined benefit plans, Section 415 provides an annual limit on the benefits that may be paid to a participant. For 2019, this limit is equal to the lesser of $225,000 or 100% of the participant’s average compensation for the three consecutive years during which he or she had the highest salary. The limit was $220,000 or 100% of the participant’s highest three-year average in 2018.
Excess Benefits Plans vs. Top-Hat Plans
Excess benefit plans differ from top-hat plans. Participation in an excess benefit plan is not limited to a select group of management or highly compensated employees. In addition, an excess benefit plan is required to be maintained solely for the purpose of providing benefits in excess of the limits contained in Code Section 415.
Why would an employer wish to establish an excess benefit plan?
There are a number of reasons why an employer might wish to establish an excess benefit plan. These include:
- Attracting qualified employees
- Retaining employees
- Providing employees with an incentive for better service and increased productivity
- Compensating participants for the loss (because of Section 415) of benefits that would otherwise be earned under the employer’s qualified retirement plans
- Encouraging early retirement for some highly paid employees by providing them with greater benefits than those permitted under the employer’s qualified retirement plans
- Providing additional deferred compensation benefits while avoiding the often burdensome requirements of the Employee Retirement Income Security Act of 1974 (ERISA)
Which ERISA requirements apply?
The avoidance of substantial requirements under ERISA is often an important element in the design of any nonqualified deferred compensation plan, including excess benefit plans. Whether an excess benefit plan is subject to certain requirements under Title I of ERISA depends on whether the plan is funded or unfunded. Unfunded means that business assets are reachable by the employer or the employer’s creditors. In other words, the money is not irrevocably set aside with a third party for the benefit of the employee. A funded plan takes the opposite approach: assets are segregated or exclusively set aside for plan participants only, and are beyond the reach of the employer’s creditors.
An unfunded excess benefit plan is exempt from all the requirements of Title I of ERISA. A funded excess benefit plan is generally subject to the reporting, disclosure, fiduciary, and enforcement provisions of ERISA. However, it is not subject to the more complicated participation, vesting, and funding rules.
Caution: It is not clear if ERISA applies to an excess benefit plan funded with an employee secular trust. This is because ERISA applies only to plans established or maintained by an employer or employer organization, and employee secular trusts are deemed to be created by the participating employees for tax purposes.
Caution: ERISA does not apply to governmental and most church retirement plans. NQDC plans maintained by governmental and tax-exempt employers are governed by a special set of rules, and are referred to as 457 plans.
How does an excess benefit plan work?
Unfunded Excess Benefit Plan
An employer generally pays the benefits provided under an unfunded excess benefit plan out of its general assets at the time the payments become due. Therefore, the employee must rely solely on the employer’s promise to pay these benefits and assumes the risk that these benefits may not be paid. For example, if the employer becomes insolvent or experiences a change of management, the benefits may not be paid at all. To increase the likelihood that the promised benefits will be paid from an unfunded excess benefit plan, an employer can make a number of arrangements to “informally fund” a NQDC plan, including establishing a rabbi trust, securing a third-party guarantee, or purchasing corporate-owned life insurance. An irrevocable rabbi trust, for example, if adequately funded, can provide participants with assurance that their benefits will be paid in all events, except in the case of the employer’s insolvency or bankruptcy.
IRC Section 409A provides specific rules relating to deferral elections, distributions, and funding that apply to most unfunded excess benefit plans. If your plan fails to follow these rules, the plan benefits of affected participants, for that year and all prior years, may become immediately taxable and subject to penalties and interest charges. It is very important that you be aware of and follow the rules in IRC Section 409A when establishing an excess benefit plan.
Funded Excess Benefit Plan
If you choose to fund your excess benefit plan, you must create a separate fund to which participants may look for payment. The assets must be set aside for the exclusive purpose of providing benefits to participants; they must not be accessible by you or your general creditors. Specific methods of funding the plan include establishing a secular trust and purchasing annuities to be used exclusively to pay plan benefits.
What are the tax consequences to employees?
Generally, there are no income tax consequences to your employee until benefits are paid from the excess benefit plan. Your employee must then include the full amount received in his or her gross income.
However, the IRS may tax an employee on contributions made to an excess benefit plan prior to the receipt of plan assets under the doctrine of constructive receipt (which requires taxation when funds are available to the employee without substantial restrictions), the economic benefit doctrine, and IRC Section 409A.
In general, your employee must include your contributions to a funded excess benefit plan in gross income in the year they’re made or, if later, in the year your employee becomes vested in the contributions — that is, when the employee’s benefit is no longer subject to a substantial risk of forfeiture. However, the specific tax consequences depend on the type of funding vehicle used.
Caution: Your employees may be taxed on contributions to a funded excess benefit plan, and investment earnings, prior to their actual receipt of the plan funds. If desired, you can pay your employee a cash bonus to cover his or her tax liability. Or, if your plan is funded with a secular trust, your employee can receive a distribution from the trust in order to pay the taxes.
A funded excess benefit plan can provide the benefit of tax deferral only if the employee’s benefit is subject to a substantial risk of forfeiture. In contrast, an unfunded excess benefit plan can provide the benefit of tax deferral even if the employee’s benefit is fully vested.
What are the tax consequences to employers?
In general, you receive a tax deduction in the taxable year your contribution is included in your employee’s gross income. This generally means that you receive the deduction in the year your employee actually receives the excess benefit plan benefits. You can deduct the total amount paid to your employee, including any earnings on your contributions.
Example: ABC Co. (employer) promises excess benefit payments to its employee, Jim. Jim earns benefits in the amount of $5,000 in Year 1, $5,000 in Year 2, and $7,000 in Year 3. In Year 4, Jim retires and receives a lump sum payment of $21,000 (which includes interest). ABC Co. will get a tax deduction in Year 4 in the amount of $21,000.
In general, you receive a tax deduction in the taxable year an amount attributable to your contribution is included in your employee’s gross income. In general, this means that you are entitled to the deduction in the year you make your contributions to the plan, or if later, the date your employee becomes vested in the contributions. You are generally not entitled to a deduction for any earnings on your contributions to a funded plan.
In order for you to receive a deduction for your contributions to a funded excess benefit plan, you generally must maintain separate accounts for each employee when more than one employee participates.
Further, a deduction is permitted only to the extent that the contribution or payment is both reasonable in amount and an ordinary and necessary expense incurred in carrying on a trade or business.
Caution: Publicly held companies can’t deduct total compensation in excess of $1 million in any one year for certain executives.
Internal Revenue Code Section 409A
IRC Section 409A, enacted as part of the American Jobs Creation Act of 2004, contains election, distribution, and funding rules that apply to NQDC plans, including certain excess benefit plans. These rules generally apply to compensation deferred after December 31, 2004 (although compensation deferred earlier is also covered in some cases). If a plan fails to comply with Section 409A’s requirements, then affected participants will be subject to income tax on their accrued benefits in the year of the failure (or if later, when those benefits vest).
The IRS has indicated that NQDC plans funded with employer secular trusts are not subject to Section 409A. It seems likely that excess benefit plans funded with employee secular trusts should also be exempt from Section 409A, but this is not entirely clear, and further guidance is expected from the Service. If you maintain, or are considering adopting, an excess benefit plan, you should consult your pension professionals regarding the application of this important law.
If you are thinking about an excess benefit plan for your business and need assistance, contact the Experts at Henssler Financial: