Non-qualified plan rules and options

Non-qualified deferred compensation, Section 409A timing rules, rabbi and secular trusts, supplemental executive retirement plans, stock options and restricted stock, and the employer and employee tax treatment of each compared with a qualified plan.

Internal Revenue Code Section 409ARabbi trust

Practice question for this objective

Free sampleRetirement Savings and Income Planningmedium

Marcus, aged 57, is deferring 120,000 dollars a year of salary under his employer's unfunded non-qualified plan and will not be paid until he retires at 65. His employer is financially sound but is a likely takeover target, and Marcus tells his planner that his real fear is a new board simply refusing to honour the promise. He wants the strongest practical assurance that the money will be there, and he is not willing to pay income tax on any of the deferred salary before it is paid to him. Which arrangement best meets both of his stated requirements?

AEstablish a rabbi trust, whose assets remain within reach of the employer's general creditors, so he is not taxed until the benefits are paid. Correct
BEstablish a secular trust, whose assets are beyond the reach of the employer's creditors, accepting that he is taxed as his interest vests.
CLeave the promise unfunded and add a clause requiring immediate payment of the whole balance on a change of control of the employer.
DHave the employer buy a life policy on his life, earmark it for the promise, and keep the policy as an unrestricted corporate asset.

A rabbi trust defers tax because its assets stay reachable by the employer's general creditors, while a secular trust protects the executive but triggers tax on vesting. The two trusts sit at opposite ends of the same trade-off, and a candidate must be able to say which risk each one answers. A rabbi trust is irrevocable as against the employer, so the company cannot change its mind and a new owner cannot redirect the assets, and that is what answers the takeover fear. Because the trust assets stay subject to the claims of the employer's general creditors, Marcus has neither received property nor obtained an economic benefit, so nothing is included in his income until benefits are paid. A secular trust removes the creditor exposure and therefore removes the reason for deferral, so the executive is taxed as the interest vests. The insolvency risk that survives a rabbi trust is real, but Marcus has said his concern is a change of control rather than the failure of a sound employer, and the rabbi trust is the arrangement that meets the requirement he actually stated without accelerating tax.

Why A is correct: A rabbi trust puts the assets beyond the reach of a later management team while leaving them exposed to the employer's general creditors, which is precisely why no current income arises for Marcus.

Why B is wrong: This gives the stronger security of the two trusts and protects even against insolvency, but placing the assets beyond creditors' claims makes the interest taxable to Marcus as it vests, which breaks his second requirement.

Why C is wrong: A change of control clause can be a valid payment trigger and does address the takeover worry, but it leaves the promise a bare unsecured claim, so a buyer who refuses to pay still leaves Marcus queuing with ordinary creditors.

Why D is wrong: Corporate owned life insurance is a common way to fund the employer's future cost, but an earmarked policy the company still owns outright is simply another general asset and gives Marcus no enforceable claim on it.

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Exam traps in Retirement Savings and Income Planning

Answers that look right on this material and are not. Each one is a distractor from a different question in the CFP bank for this domain.

The employer deducts the deferred amount in the year it is credited to her account, in the same way as a contribution to a qualified plan.
Why it is wrong: This is tempting because the accrual method normally allows a deduction when the liability is fixed, and it is exactly how a qualified plan contribution works, but deferred compensation is carved out of the ordinary accrual rules and cannot be deducted before the employee is taxed.
A safe harbour 401(k) with a 3 percent non-elective employer contribution for every eligible employee
Why it is wrong: A safe harbour design does remove the deferral testing, which makes it superficially attractive here, but it is a qualified plan with a trust, an annual Form 5500 and a plan document to maintain, so it fails his stated requirement for minimal administration.
32,500 dollars in total, because a single elective deferral limit is shared across both plans
Why it is wrong: This applies the aggregation rule that genuinely does govern a 403(b) and a 401(k) held by the same person, but a governmental 457(b) is not aggregated with either of them, so a second full limit is available.

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