For employees whose benefits under the employer’s qualified retirement plan are constrained by the application of Internal Revenue Code (IRC) Section 415, an excess benefit plan is a nonqualified deferred compensation (NQDC) plan that offers supplementary retirement income benefits. Simply put, the excess benefit plan’s objective is to enable employees who take part in qualifying plans to go above the restrictions established by Section 415. 

The benefit offered to an employee under an excess benefit plan typically consists of the difference between the benefit they would have gotten under the employer’s eligible retirement plan had the Section 415 limitations not been applied and the benefit they actually get under the plan.

Reasons for Establishing an Excess Benefit Plan

An employer could want to create an excess benefit plan for a number of reasons. These consist of:

  • Securing talented personnel
  • Retaining personnel
  • Giving staff members a reward for greater performance and higher output
  • Compensating members for the loss of benefits they would have otherwise accrued under the qualified retirement plans of the employer (due to Section 415)
  • – Encouraging certain highly compensated employees to retire early by offering them benefits above and beyond those permitted by the employer’s eligible retirement plans

extending the benefits of deferred compensation while avoiding the frequently onerous rules of the Employee Retirement Income Security Act of 1974 (ERISA)

How Does an Excess Benefit Plan Work?

Unfunded Excess Benefit Plan

When benefits under an unfunded excess benefit plan become due, a company typically pays them out of its general assets. As a result, the employee is forced to rely only on the employer’s assurance that these benefits would be provided and accepts the possibility that they won’t. Benefits might not be paid at all, for instance, if the firm has a management change or goes bankrupt. Employers may “informally fund” a NQDC plan in a number of ways, such as by creating a rabbi trust, obtaining a third-party guarantee, or buying corporate-owned life insurance, to improve the possibility that the promised benefits will be paid from an unfunded excess benefit plan. If properly funded, an irrevocable rabbi trust, for instance, might give participants peace of mind that their benefits will be paid in all circumstances, barring the employer’s insolvency or bankruptcy.

The majority of underfunded excess benefit plans must adhere to the precise regulations in IRC Section 409A regarding deferral elections, distributions, and funding. The plan benefits of impacted participants for the current year and all preceding years may become instantly taxable and subject to penalties and interest charges if your plan violates these regulations. It is crucial that you understand and abide by the regulations in IRC Section 409A while creating an excess benefit plan.

Funded Excess Benefit Plan

You must establish a separate fund where members may look for payment if you decide to fund your excess benefit plan. The assets must not be accessible to you or your general creditors and must be put aside only for the purpose of providing benefits to participants. Establishing a secular trust and ac

Tax Consequences of Excess Benefit Plan to Employees

Unfunded Plan

Until payments from the excess benefit plan are paid out, generally speaking, your employee is not subject to income tax penalties. The full sum received must subsequently be included in your employee’s gross income.

However, the doctrine of constructive receipt (which mandates taxation when funds are made available to the employee without substantial restrictions), the economic benefit doctrine, and IRC Section 409A allow the IRS to tax an employee on contributions made to an excess benefit plan prior to receiving plan assets.

Funded Plan

Generally, your contributions to a funded excess benefit plan must be included by your employee in gross income in the year you make them or, if later, the year your employee becomes vested in the contributions, which is the year the employee’s benefit is no longer subject to a significant risk of forfeiture. The particular tax repercussions, however, vary depending on the funding method used.

Attention: Prior to receiving plan funds, your employees’ contributions and investment earnings to a funded excess benefit plan may be taxed. You can give your worker a cash incentive if you’d like to take care of their tax obligations. Alternatively, if your plan is backed by a secular trust, your employee may obtain a dividend from the trust to cover the tax bill.

Only if the employee’s benefit is subject to a significant risk of forfeiture can a financed excess benefit plan offer the benefit of tax deferral. In contrast, even if the employee’s benefit is fully vested, an unfunded excess benefit plan might offer the benefit of tax deferral.

An excess benefit plan may have tax advantages and be a formidable tool for conserving money. It’s critical to comprehend how exactly that money can be returned to you and how you could be able to maximize its potential. Let’s look at some of the important factors you need to take into account when operating an excess benefit plan.

Planning Strategies for Excess Benefit Plans

Understand Excess Benefit Plans

There are IRS restrictions on the maximum annual contributions that an individual can make to any company-sponsored retirement plan. Once you’ve reached that threshold, there is no longer a tax-deferred way to save for retirement. An excess benefit plan can be useful in this situation. Employees can continue saving through this employer-sponsored, tax-deferred plan by postponing the portion of their pay that doesn’t “fit” into their 401(k), IRA, or other retirement plan. The employee will eventually be due this payment, usually at or around retirement. An excess benefit plan is distinct from a 401(k), a Roth 401(k), or a 403(b) since it is managed by the employer and the money in it belongs to the employee. Therefore, unlike money in an IRA or 401(k), which belongs to you immediately, money in an excess benefit plan does not become your property until it is disbursed. This affects how you should handle your retirement.

Plan Your Future

Your personal financial horizon and how you expect to live your life will determine how you elect to accept the money from your excess benefit plan. Just a few crucial things to think about include plans for a new home, paying for college, loan payments, and charitable obligations. Making sense of your long-term timetable can be challenging when preparing years in advance. If you need assistance, speak with your financial counselor. Whatever your goals, you should consider whether your spending will increase or decrease as you approach your excess benefit plan since it has a significant impact on how you handle your income tax.

Installments and Income Tax

When you get money from an excess benefit plan, it is taxed at the current rate of your income tax. This is interesting to retired people: Allowing someone to postpone receiving compensation until later in life allows them to get it when their income tax rate is lower, necessitating them to pay less tax than they otherwise would have. According to their demands, those who want this result can choose to receive their money in installments, which will be given to them annually, quarterly, or regularly. The biggest advantages come from spreading out payouts over a longer period of time, but only if the retiree can reduce their overall amount of taxable income. This amount can be decreased in a variety of ways, including by altering your purchasing patterns and giving to charity. Explore your choices by speaking with us. Last but not least, it’s significant to remember that excess benefit plans have the advantage of tax-deferred compounding. This gives you the opportunity for potential tax-deferred market growth, which is another reason to keep money in the fund.

Getting Paid in Full

People with excess benefit plans have the option to choose a lump sum payment instead of getting their money through scheduled distributions; this payment is frequently made upon retirement. Those who choose this option will have their funds taxed at their current income tax rate. This might incur a higher tax liability in some circumstances than if the money had been dispersed gradually. So why would you choose a lump sum instead? If an employee felt uneasy leaving their d

Excess benefit plans, as we previously discussed, are managed by the business that employs the worker and will be returned at a later time. You could lose all or part of the compensation you deferred if the business goes out of business or is unable to pay these monies. Because of this, worries about the viability or future of the company may inspire an employee to withdraw their money, bear the immediate tax consequences, and use them for more secure retirement or investment endeavors.