Unlike a qualified plan, where money is set aside and segregated for the benefit of the plan participants and is protected from the creditors of the business, a non-qualified executive benefit plan can only be "informally" funded. This means that any asset used to fund a non-qualified plan is subject to creditors of the business. The business owner is not required to fund the non-qualified plan, but is generally advised that they do so in order to have the money on hand to pay the benefits when they are due. Options for funding a non-qualified benefit are: Self-Fund, Sinking Fund, Annuities, or a Life Insurance Policy. Let's review each option:
SELF-FUNDED
The employer pays the retirement benefits from the current cash flow of the business at the time the benefits are payable. A self-funded plan does not have an immediate impact on the company's cash flow when established, but there is a risk that cash flow will not be available in the future.
SINKING FUND
The employer sets up a reserve or sinking fund where cash is invested. Benefits are paid from the sinking fund when the employee retires. The employer assumes the market risk and often invests in high-risk assets to meet its future obligations. The employer must pay income taxes on the fund earnings each year.
ANNUITIES
Similar to the sinking fund, the non-qualified benefits owed to key employees is taken from the annuity. Under the tax code, however, business entities cannot achieve income tax deferral with deferred annuities.
LIFE INSURANCE
Life insurance is a popular funding tool for non-qualified plans because it is cost effective, has tax deferred accumulation to fund benefits, and the employer may be able to recover all costs of the plan with the death benefit proceeds.
