III. Nonqualified Deferred Compensation Plans
Executives and other highly compensated employees frequently receive a portion of their compensation in the form of tax-deferred savings under a nonqualified deferred compensation plan such as a SERP or other “top-hat” plan. As a general matter, until these amounts are paid to the recipient and taxed as ordinary income, the benefits are treated for legal purposes as simply an unfunded promise of the employer’s to pay the employee some stated amount in the future. Employers may set aside assets toward the payment of nonqualified deferred compensation benefits into a “rabbi” trust, but even so the plan is still treated as “unfunded” because assets in the rabbi trust remain available to the employer’s creditors.
Because of the unfunded nature of nonqualified deferred compensation benefits, these benefits are generally unavailable to creditors. The recipient does not have legal title to the benefits until distributed, and there is no specific pool of assets available for creditors to attach. However, depending on how the employer has chosen to design the plan, it is possible that the nonqualified deferred compensation benefits may be subject to certain kinds of creditor claims. For instance, it is common for nonqualified plans to provide for division of assets to satisfy a domestic relations order, similar to the QDRO rules applicable to ERISA plans. Additionally, many nonqualified plans also provide that benefits can be reduced to satisfy any personal indebtedness of the employee to the employer. Generally, however, third-party creditor claims other than those arising through domestic relations orders cannot be satisfied by attaching an employee’s interest in a nonqualified deferred compensation plan.
An executive with a nonqualified deferred compensation plan balance may thus prefer that benefits remain unpaid until a future date for asset protection purposes. Once the benefits are paid to the employee, they become subject to the claims of creditors and do not qualify for rollover to an IRA or other protected vehicle. Depending on the design of the plan, it may be possible for a participant in a nonqualified plan who is due to take a distribution at some specific date to postpone the distribution five years or longer into future (it is generally prohibited under section 409A of the Internal Revenue Code to postpone a scheduled distribution for a period of less than five years).
Every nonqualified plan is different, so review the applicable plan documents to determine to what extent assets are protected from claims of creditors, and also whether “redeferral” elections are permitted in order to strategically postpone a distribution for asset protection purposes.
IV. State Government Retirement Benefits
Employees of a state government or affiliated institution such as a state college or university may be eligible to participate in plans unavailable to employees of private sector employers, such as 457 plans state retirement systems. Plans sponsored by a governmental entity are exempt from most parts of ERISA, so the protections that generally apply to ERISA plans do not apply to all governmental plans on the same terms. Under federal bankruptcy law, however, benefits provided under a qualified plan or a governmental 457 or 403(b) plan are treated as exempt to the same extent as assets under an ERISA plan.
With respect to state retirement systems, state law will dictate to what extent these assets are protected from creditors. Under Virginia law, benefits accrued under the Virginia Retirement System (VRS) or its related plans, such as the Optional Retirement Plans, are generally protected from the claims of creditors, with three exceptions:
1. Process to recover debt to any employer who has employed the individual;
2. Administrative actions or court orders to enforce child or spousal support payment obligations; and
3. Division of retirement assets to the extent they constitute marital property for purposes of state law.
These protections are weaker than those applicable to ERISA plans and even IRAs in two respects. First, benefits accrued under the VRS plans are subject to the claims of employers, while ERISA plans and IRAs are protected against the claims of employers to the same extent as the claims of other third-party creditors. Second, benefits accrued under the VRS plans are subject to a wider range of enforcement actions to collect child or spousal support or to divide marital property than are ERISA plans, since Virginia law allows administrative actions to collect VRS assets even without a court order as would be required with respect to an ERISA plan.
Residents of Virginia who are eligible for a distribution from the VRS or an ORP should generally prefer to roll the distribution into an IRA (to the extent that the distribution is eligible for rollover) as soon as possible rather than leaving the assets in the state plan. The asset protection rules applicable to IRAs under current Virginia law are stronger than those applicable to the VRS plans. However, as noted above, any decision to roll assets into an IRA should be considered carefully if relocation to another state is anticipated in the future. –Shad C. Fagerland