It is possible to fund non-qualified deferred compensation plans with life insurance in certain circumstances. A non-qualified deferred compensation plan is a binding contract between an employer and an employee where the employer agrees to pay the employee at a later time. Specifically, the employer makes an unsecured promise to pay an employee's future benefits, subject to the specific terms of the contract. These types of plans differ substantially from qualified plans, like a 401(k), which has stricter rules investors must follow and typically has an income cap. Non-qualified deferred compensation plans are not limited by income.

With non-qualified deferred compensation plans, an employer can offer bonuses, salaries, stock options, retirement plans other than 401(k)s, and other kinds of compensation, without having to make the payments right away. By deferring the payment and providing it at a later date, the employer is enabling the employee to also defer paying taxes on this future compensation.

Key Takeaways

  • A non-qualified deferred compensation plan is a contract made between an employee and their employer that says the employer will cover the cost of the employee's benefits in the future, as per the contract's terms.
  • These plans are unfunded and have two parts: a contractual agreement between the employer and hire, and the employer's general asset reserve that covers future costs created by the plan.
  • Two types of non-qualified deferred compensation plans allow life insurance funding: supplemental executive retirement plans (SERPs) and corporate-owned life insurance (COLI).

Funding Nonqualified Deferred Compensation Plans

Non-qualified deferred compensation plans are unfunded plans that are broken into two parts. The first part is the plan itself, which is equivalent to the contractual agreement between the employer and employee. The second part is the employer's general asset reserve that finances the future liabilities created by the plan. The general asset reserve is what the employer uses to pay the employee for future benefits.

The general asset reserve is required by generally accepted accounting principles (GAAP) and can be taxable assets such as mutual funds or employer-owned life insurance. The plan is the legal benefit between the plan participant (the employee), and the plan sponsor (the employer). The plan outlines the overall benefits, distribution schedule, and vesting and forfeiture stipulations.

Non-qualified deferred compensation plans are often used by executives who want to defer income taxes on what they are earning.

Types of Plans That Allow Life Insurance Funding

It is possible to fund non-qualified deferred compensation plans with life insurance. There are two main funds that allow life insurance funding: supplemental executive retirement plans (SERPs) and corporate-owned life insurance (COLI). SERPs are similar to defined-benefit pension plans and give an employee a stated benefit provided by the employer at the time of retirement.

With corporate-owned life insurance (COLI), companies purchase life insurance policies on employees whom they wish to compensate. The company pays the premium on the life insurance policies and then pays out benefits to the employees when they retire.

(For related reading, see "How Non-Qualified Deferred Compensation Plans Work.")