Tax-Free Retirement Savings Plan for Executives of Tax-Exempt Organizations

Tax-exempt organizations (TEOs) face unique challenges when it comes to compensating and retaining top executive talent—especially when competing with for-profit and publicly traded companies. Many TEOs operate with billion-dollar budgets, yet their ability to provide meaningful retirement benefits is significantly constrained by federal tax rules.

Key among these constraints are Internal Revenue Code (IRC) sections 4960 and 4958:

• IRC Section 4960 imposes a 21% excise tax on executive compensation exceeding $1 million.
• IRC Section 4958 requires executive compensation to be “reasonable.” If any amount is deemed “unreasonable,” it must be repaid to the organization. The executive also faces a 25% excise tax, increasing to 200% if the excess is not repaid by the end of the year.

In addition to these compensation limits, TEOs are restricted in the types of retirement benefits they can offer. Specifically, they cannot provide nonqualified deferred compensation or supplemental executive retirement plans—benefits commonly offered in the for-profit sector.

Instead, TEOs are limited to:

• Qualified retirement plans, which have strict contribution limits and are subject to the Employee Retirement Income Act and complex tax regulations.
• IRC Section 457 plans, including:
  • 457(b) plans, which offer modest retirement benefits.
  • 457(f) plans, which are highly restrictive and have complex vesting rules.

A Strategic Solution: Loan Regime Split Dollar Retirement Savings Plans

A loan regime split dollar retirement savings plan provides an innovative, tax-efficient alternative for executive retirement benefits. These plans offer several major advantages, including:

• Avoidance of IRC 4960 and 4958 Limits. Contributions to the plan are not considered “compensation” under these provisions, meaning they are not subject to the excise taxes or reasonableness tests.
• No Compensation Expense. For accounting purposes, contributions are recorded as a balance sheet receivable, not as a profits and loss compensation expense.
• Tax-Free Benefits. Contributions and distributions are both tax free. This compares favorably to traditional plans, where benefits are taxed at federal and state rates totaling 37–50%, depending on the executive’s residence.

How It Works

These plans are structured using life insurance to fund a targeted benefit. Funding can be based on one or more of the following:

• A rollover from an existing 457(f) plan,
• A “deferral” of compensation by the executive, or
• Employer contributions.

The executive owns the policy and can access the cash surrender value via policy loans—similar to variable life insurance products. Meanwhile, the employer retains a contractual right to reimbursement for premiums paid, which are typically recovered from the death benefit.

Importantly:

• The executive controls the policy and has broad access to the benefits.
• The employer records a receivable, as opposed to compensation expense.
• The plan carries no more market risk than a 401(k).
• The only cost is the insurance component—approximately 15%, which is significantly lower than the combined income tax burden on other retirement plan distributions.

Another key advantage is that executives can generally access funds at any time, unlike traditional qualified plans or 457 plans, which impose significant access restrictions.

Learn More

The success of a loan regime split dollar retirement savings plan lies in the details. For a customized illustration or more information, contact:

Manatt, Phelps & Phillips
(415) 291-7441