The ability to defer compensation can be a critical component of the financial planning of highly paid individuals. State universities and other governmental employers generally do not have the same tools to enable highly paid employees to defer compensation as are available to executives in the for-profit world. However, special rules for governmental employers allow surprising flexibility.
State universities generally have some employees with very high salaries. For smaller schools, maybe only the president fits this category. For larger schools with a Division I athletic program or a medical school, several highly-paid employees may have a sufficiently high level of compensation that they would like to defer significant amounts so that their entire salary is not currently taxable.
Standard retirement programs are constrained in the amounts of compensation that can be deferred. For example, employee deferrals for 2016 under a 403(b) plan are limited to $18,000 per year, plus an additional $6,000 of catch-up contributions for an employee who is at least 50 years old. Section 457 of the Internal Revenue Code (Code) limits the amount that can be deferred for 2016 to a nonqualified plan of a governmental employer to an additional $18,000 plus a $6,000 catch-up contribution without putting the amount at risk of forfeiture. Defined contribution and defined benefit plans typically provide contributions or benefits that are a uniform percentage of each employee’s compensation.
Unique rules apply to governmental employers. First, qualified retirement plans that are sponsored by a governmental employer are not subject to nondiscrimination rules. Therefore, while governmental qualified plans are subject to the limitations of Code section 415 (with some modifications), it is possible to have a single participant plan to provide an enhanced benefit to a university president, football coach, or other highly-paid employee who would like to receive a significant portion of compensation as a deferred benefit.
For example, it may be possible to provide an annual benefit of up to $210,000 beginning at age 65 under a single-participant qualified defined benefit plan. Alternatively, up to $53,000 may be contributed annually to a single-participant defined contribution plan for a highly paid employee.
Second, Code Section 414(m) allows a governmental employer to establish a “qualified governmental excess benefit arrangement.” A qualified governmental excess benefit arrangement works in tandem with a qualified retirement plan to allow benefits in excess of the limits under Section 415 of the Code that apply to a qualified plan. As a nonqualified plan, payments from a qualified governmental excess benefit arrangement may not be rolled over to an IRA. Importantly, though, a qualified governmental excess benefit arrangement is not subject to the restrictions on non-qualified deferred compensation contained in Section 409A of the Code.
Suppose that the head coach of a Division I state university football team has a total annual compensation package of $1,000,000. As part of Coach’s contract negotiations, the University agrees to credit Coach with an employer contribution to a qualified pension plan valued at $400,000 per year, and salary of $600,000, which could save Coach $150,000 or more in current income taxes, depending on Coach’s tax circumstances. Because the $400,000 annual value of pension plan credits will quickly exceed the maximum benefit that Section 415 allows to be provided under a qualified plan, the University also adopts a qualified governmental excess benefit arrangement. Any portion of the promised annual $400,000 benefit that exceeds the Section 415 limit will be provided instead under the qualified governmental excess benefit arrangement.
What This Means to You
Colleges and universities should work with their employees to structure compensation in a manner that maximizes benefits while serving institutional missions, financial goals, and employee returns. With careful planning and the assistance of knowledgeable professionals, deferred compensation arrangements can support not only employees, but also the college or university community as a whole.