Salary Continuation Plans

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A salary continuation plan is an agreement whereby the employer agrees to continue the employee's salary at retirement, death or, in some cases, disability. A salary continuation plan differs from a deferred compensation plan in that in the deferred compensation plan the employee essentially funds the plan through the employee's deferred wages. In the salary continuation plan, the employer funds the plan as an additional benefit.

The agreement generally requires the employer to pay the employee (or his assignee) continuing payments upon retirement in return for the employee's continued employment with the employer during the term of the agreement. Generally the employee agrees to not compete with the employer for a period of time or in a specific geographic location. If the employee leaves the employee of the employer, the agreement terminates.

Benefits are often expressed in terms of a percentage of salary and length of service, starting at retirement and extending for a period of time. Some agreements also have provisions for death benefits as well as for benefits to be paid if the employee becomes disabled prior to retirement.

The cost of the plan is directly related to the benefits provided. An internal fund could be established by the employer to meet the obligations of the agreement; however, there are potential downsides to creating a fund for that purpose. For example, corporations would have the accumulated earnings tax to consider for unused funds, the funds could be exposed to the employer's creditors, etc.)

The ideal way to fund the plan is to purchase a life insurance policy on each employee involved in the plan. The employer applies for the insurance, pays for the premiums and is the beneficiary of the life of each employee. The employer then has options to address the policy benefits as they relate to each employee:

the employer can either pay the benefit out of available cash and be reimbursed by the death benefit at the employee’s death
the employer can borrow against the cash value of the insurance policy to meet its obligations to the employee
if the employee dies, the employer can recover all of the employer's costs from the death benefit.

The employer does not receive a tax deduction on the premiums paid since the company is both the owner and the beneficiary of the policies. If the employer surrenders the policy, the difference between the cash received and the premiums paid by the employer is taxed as ordinary income. If the employer does not surrender the policy and keeps it in force, the employer receives the death benefit tax free at the employee's death.

As a nonqualified incentive plan, the employer can discriminate among employees and offer the plan to key executives or other key employees. It is ideal for highly compensated executives who find themselves in higher tax brackets with each raise or bonus received as it defers income from peak earning years to some future years, usually retirement, when the highly paid executive is in a lower tax bracket.

The plan has several key advantages:

IRC ERISA regulations are not applicable to nonqualified plans
employers are free to select the eligible participants and benefits are flexible
the plans help recruiting and retention of key employees
the plans can be discontinued at any time
they are easy to establish ad administer
the employee does not have to report taxable income until the benefits are actually received
the company can recover all costs of the plan through properly designed plans

Any agreements and insurance policies within a business must be integrated with the overall plan and objectives of the business. Careful consideration must be given to the selection of the plan which is right for your business and to the method of funding your plan.

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This material contains only general descriptions and is not a solicitation to sell any insurance product or security, nor is it intended as any financial or tax advice. For information about specific insurance needs or situations, contract your insurance agent. Our articles are intended to assist in educating you about insurance generally and not to provide personal service. They may not take into account your personal characteristics such as budget, assets, risk tolerance, family situation or activities which may affect the type of insurance that would be right for you. In addition, state insurance laws and insurance underwriting rules may affect available coverage and its costs. If you need more information or would like personal advice you should consult an insurance professional. You may also visit your state’s insurance department for more information.