Executive Compensation Tax: Employee Benefit Plans

This is the second in a series of two articles discussing executive compensation taxation. This article covers some of the tax implications of employee benefit plans. The first article provides tax insights on options, stock grants and bonuses. Read it here.

Tax News You Can Use | For Professional Advisors

Jane G. Ditelberg, Director of Tax Planning
Anthony Rodriguez, Director of Retirement Planning

Executive compensation decisions can be complex and each have unique tax implications that impact each benefit’s relative value. This guide provides an overview of the tax treatment for common forms of executive compensation, including defined contribution plans, defined benefit plans and non-qualified employee benefit plans. Understanding the tax treatments – and timing – of these forms of compensation is critical to maximize the value of executive benefits.

Defined contribution plans

Executives often participate in qualified plans offered by their employers, including 401(k), 403(b), profit sharing and employee stock ownerships plans, all of which are types of defined contribution (DC) plans. Under a DC plan, the employee earns the right to a specific contribution to the plan, whether that contribution is made by the employee or by the employer, rather than a specific distribution at the time of retirement. These amounts stay in the plan until a later date, when the executive is entitled to withdraw them. The amount ultimately received is driven by the investment performance of the assets while they are in the plan.

In some cases, the employee funds all of the contributions to their account via payroll withholding. In others there are both employee contributions and employer matching contributions. And then there are those, like most profit-sharing plans, that are funded entirely by the employer, which may require the executive to remain at the company for a period of time before being entitled to employer contributions.

Employer contributions to DC plans can grow income-tax-free inside the plan and are taxed as ordinary income when the assets are withdrawn from the plan. Employee contributions to DC plans up to an annual cap (which is adjusted for inflation and has higher limits for older employees) are deductible from income when the contribution is made. When the assets are withdrawn, including the initial contributions and the earnings and appreciation on those contributions, they are treated as ordinary income. By deferring the tax, the assets have a better chance at growing in value than assets invested outside a DC plan.

Some DC plans allow a participant to make contributions in excess of the cap on deductible contributions. These amounts are treated as having a basis equal to the amount of the contribution, and are subtracted from the total when the amount of ordinary income is computed when assets are withdrawn. Other plans allow DC accounts that are treated as Roth plans — where there is no deduction for the contributions, no income tax on earnings and accumulations, and no income tax on any of the “qualified”¹ amounts when they are withdrawn.

Defined benefit/pension plans

Defined benefit (DB) or pension plans provide the employee with a fixed benefit payable at retirement, typically based upon a formula tied to the employee’s compensation during specified working years. The employer funds the plans based on actuarial projections and holds those assets in the pension plan. All investing is done by the employer or its agents, and the DB plan’s obligation to pay the employee remains the same regardless of how the investments perform. Upon retirement, the employee may have the option to elect a lifetime annuity, a joint annuity with their spouse, or a lump sum payout. There may also be a payout at the employee’s death. These payments, whenever received, will constitute ordinary income for tax purposes.

Non-qualified employee benefit plans

Non-qualified plans are typically deferred compensation plans that withhold payment of a part of an employee’s compensation until a later date. The plan may be mandatory (employee only gets the funds if they defer) or elective (employee determines whether and how much to defer). Non-qualified plan deferrals do not need to be tied to retirement dates, so they can be used to save for other goals, such as funding education or buying a vacation home. Note that these payout dates need to be established up front before the income is deferred, and the deferred amount is taxed as ordinary income when received.

In some cases, the plan is merely an unsecured and unfunded promise to pay the employee at the future date, while others have funding mechanisms. Some are available only to a specific individual as part of an employment contract, while others have a plan document that determines which employees are eligible participants. A rabbi trust is one type of non-qualified plan where the employer deposits assets in an irrevocable trust for the executive. These assets are subject to the claims of the employer’s creditors. Other plans, called secular plans to distinguish them from rabbi trusts, keep employee assets separate from the company’s assets, thus protecting them from claims by the employer’s creditors.

If you have questions about the taxation of executive compensation, please contact your Northern Trust advisor.

This article is the second in a two-part series. The first article focuses on taxation impacting executive compensation such as options, stock grants and bonuses. Read the first article here.