August 5, 2026
9:45 pm

Policies Funding Deferred Compensation Plans

A life insurance policy bought to fund a nonqualified deferred compensation plan is an informal funding asset, not a segregated benefit – the company owns it, the company’s general creditors can reach it, and the executive has only an unsecured promise to be paid. That structure is deliberate, because formal funding would destroy the tax deferral the plan exists to provide. Understanding it is the key to every decision about the policy.

Companies pair COLI with deferred comp because the economics line up. Premiums are not deductible, but cash value grows tax-deferred and the death benefit is generally received income-tax-free by the employer if IRC Section 101(j) requirements were satisfied. That combination lets an employer accumulate an asset that roughly tracks a liability whose payments will be deductible when made.

This page covers the mechanics, the rabbi trust, the Section 409A constraints, and every option for the underlying policy – with a blunt statement of when selling it is the wrong answer. Pine Lake Life Solutions offers a free policy review; it is not a law or accounting firm and does not provide legal, tax, or investment advice.

In This Article

Why the Funding Has to Stay Informal
What a Rabbi Trust Does and Does Not Do
Section 409A Constrains the Timing, Not the Asset
IRC 101(j) and the Value of the Death Benefit
Options for the Policy, Compared Honestly
When Selling the Funding Policy Is Wrong
An Annual Review Discipline and Disclosures
Frequently Asked Questions

Policies Funding Deferred Compensation Plans

Why the Funding Has to Stay Informal

The doctrines of constructive receipt and economic benefit drive the whole design. If an executive has a vested, secured right to assets set aside for their benefit, they are generally taxed currently even though no cash has been paid. Deferral therefore requires that the promise remain unsecured and the assets remain subject to the employer’s general creditors.

This is why COLI supporting a supplemental executive retirement plan is owned by the company, names the company as beneficiary, and appears on the company’s balance sheet at cash surrender value. Any arrangement that pledges the policy to the executive, or places it beyond creditors’ reach, risks collapsing the deferral.

Practically, the executive holds a contractual claim ranking with other unsecured creditors in a bankruptcy. That is a real risk, not a theoretical one, and it is why participants should read the plan document rather than assuming a policy with their name in the file is somehow theirs.

What a Rabbi Trust Does and Does Not Do

A rabbi trust – so named for the 1980 private letter ruling involving a congregation and its rabbi – is an irrevocable grantor trust holding the funding assets, including COLI. It protects the executive against a change of heart, a change of control, or new management refusing to pay. It does not protect against insolvency: trust assets remain reachable by the employer’s general creditors, which is exactly what preserves the deferral.

The IRS published a model rabbi trust in Revenue Procedure 92-64, and most documents in use follow it closely. Deviating from the model invites scrutiny, so plan sponsors typically stick to the template.

Contrast this with a secular trust, which does put assets beyond creditors’ reach – and triggers current taxation to the executive as a result. If someone tells you a deferred comp arrangement is both tax-deferred and creditor-proof, ask them to show you the authority. Related: how trust-owned policies are handled.

Section 409A Constrains the Timing, Not the Asset

IRC Section 409A, enacted by the American Jobs Creation Act of 2004, governs nonqualified deferred compensation. It requires deferral elections to be made in advance, restricts the permissible payment events to a short list including separation from service, disability, death, a fixed schedule, a change in control, and unforeseeable emergency, and generally prohibits acceleration.

Failure carries a harsh penalty: the deferred amount becomes immediately includible in income, plus a 20% additional tax and interest charges, imposed on the executive rather than the employer.

Important distinction: 409A governs the plan and its payment timing. It does not dictate what the employer does with the funding asset. A company can surrender, exchange, or sell a COLI policy without a 409A event, because the policy is a corporate asset and not the participant’s benefit. What it cannot do is accelerate or restructure the promised payments to match a liquidity need. Confirm application to your plan with ERISA counsel as of 2026.

Question	Qualified Plan (401(k))	Nonqualified Deferred Comp with COLI
Assets protected from company creditors?	Yes, held in trust for participants	No – general creditors can reach them
Who owns the funding asset?	The plan trust, for participants	The employer
Contribution limits	Statutory annual limits apply	No statutory limit; plan terms govern
Employer deduction timing	When contributed	When benefits are actually paid
Governing rules	ERISA and the Internal Revenue Code	IRC Section 409A; top-hat ERISA exemption
Effect of a rabbi trust	N/A	Protects against a change of heart, not insolvency

Section 409A Constrains the Timing, Not the Asset

IRC 101(j) and the Value of the Death Benefit

For policies issued after August 17, 2006, Section 101(j) – added by the Pension Protection Act of 2006 – makes employer-owned death benefits taxable above premiums paid unless written notice and consent were obtained from the insured before issue and a statutory exception applies. Employers report these contracts annually on Form 8925.

This is the single most common defect found when a company reviews its COLI. Plans set up in a hurry in 2007 or 2012 frequently lack the notice and consent file, which means the asset the CFO believes is worth a tax-free death benefit may deliver far less.

Two practical steps: audit the consent documentation for every post-2006 contract, and confirm whether any pre-2006 contract has been materially modified in a way that pulls it into 101(j). If the documentation is missing, the tax analysis of every subsequent option changes – see how this plays out when a business is sold.

Options for the Policy, Compared Honestly

Keep and continue funding. The default when the liability is live and the contract is performing. Watch cost of insurance escalation on older universal life – see rising UL costs.

1035 exchange. Reposition cash value tax-free into a lower-cost or more guaranteed contract. Often the most valuable single move on an underperforming policy.

Reduce the face amount. Where the liability has shrunk – after a participant leaves or a benefit is paid out – a face reduction cuts the premium without abandoning the strategy.

Surrender. Provides cash surrender value; gain above basis is ordinary income to the company, and the liability becomes unfunded.

Transfer to the insured. A statutory exception to the transfer-for-value rule under Section 101(a)(2), and a clean way to hand coverage to a departing executive.

Life settlement. A lump sum, generally 10% to 35% of face value and roughly 4 to 8 times surrender value per the federal GAO’s study (GAO-10-775), for policies of about $100,000 or more with a cooperating insured typically 65 or older.

When Selling the Funding Policy Is Wrong

The clearest case: the plan liability is still outstanding. Converting the funding asset to cash that then gets spent on operations leaves an unsecured promise with nothing behind it. If the company needs liquidity, that is a financing conversation, not an insurance conversation.

Also wrong when the insured executive is under 65 and healthy – secondary market pricing is driven by life expectancy underwriting, and those policies typically draw weak offers or none. Wrong when the face amount is modest; buyers generally will not engage below roughly $100,000, and small final expense contracts are never candidates.

And wrong without the insured’s cooperation, because any transaction requires a HIPAA authorization and life expectancy underwriting. A retired participant has every reason to ask what they get out of it.

A market check is reasonable when the participant has died or been paid out and the policy has no remaining purpose, when premiums are escalating on an old contract, or when the company is winding down. See COLI in a dissolving company.

An Annual Review Discipline and Disclosures

Companies should review COLI supporting deferred comp annually, not at renewal-by-inertia. The file should contain, each year: an in-force illustration projecting to age 95, the current cash surrender value and any loans, a comparison of policy values against the projected plan liability, confirmation that 101(j) documentation exists, and the Form 8925 filing.

If the asset and liability have drifted apart – which happens routinely when cost of insurance rises faster than illustrated – that is the moment to consider an exchange or a face adjustment, long before the contract is in trouble.

If an objective market value would help the analysis, a free policy review starts with the policy cover page showing carrier, policy number, face amount, and issue date. No cost, no obligation. Call (305) 209-7183.

Pine Lake Life Solutions provides educational information and free policy reviews only. It is not affiliated with any insurance carrier, is not a law or accounting firm, and does not provide legal, tax, or investment advice. Sections 409A, 101(j), and 101(a)(2) are technical; confirm each with your own advisers as of 2026.

Frequently Asked Questions

Why does the company own the policy instead of the executive?

Because giving the executive a secured, vested interest in the asset would trigger current taxation under the constructive receipt and economic benefit doctrines, destroying the deferral. Keeping the policy as a general corporate asset subject to creditors is what preserves the tax treatment. The executive holds a contractual promise, not an ownership interest.

Does a rabbi trust protect my deferred compensation?

It protects against the employer changing its mind, being acquired, or simply refusing to pay, because the trust is irrevocable. It does not protect against the employer’s insolvency, since trust assets remain reachable by general creditors. The IRS published a model rabbi trust in Revenue Procedure 92-64 that most plans follow.

Can the company sell the policy without affecting my benefit?

Generally yes, because the policy is a corporate asset and your benefit is a contractual promise governed by the plan document. What the company cannot do is change your payment timing to match its liquidity needs, which Section 409A restricts. Ask the plan sponsor to confirm in writing that the benefit is unchanged.

What is IRC Section 409A and what happens if a plan violates it?

Section 409A governs nonqualified deferred compensation, requiring advance deferral elections and limiting payment to a defined list of events such as separation from service, death, disability, or a fixed schedule. A violation makes the deferred amount immediately taxable to the participant, plus a 20% additional tax and interest charges. The penalty falls on the executive, not the employer.

Why does everyone ask about notice and consent?

Because IRC Section 101(j), added by the Pension Protection Act of 2006, makes employer-owned death benefits on policies issued after August 17, 2006 taxable above premiums paid unless the insured received written notice and gave written consent before issue. Employers also file Form 8925 annually. Missing documentation materially reduces the asset’s value.

The participant retired and was paid out. What do we do with the policy?

The liability is gone, so the policy no longer serves its original purpose. Options include keeping it as a corporate asset, transferring it to the insured under the transfer-for-value exception, surrendering it, or checking whether the secondary market values it above surrender. Model the tax outcome of each before the board acts.

How do we find out if the policy has market value?

Send the policy cover page showing carrier, policy number, face amount, and issue date for a free review, and confirm the insured is willing to sign a HIPAA authorization. There is no cost and no obligation. If the policy is not a candidate, you will hear that directly rather than being strung along.

Find out what your policy is worth — free, confidential, no obligation.

A 15-minute educational review covers your eligibility, every alternative, and a realistic view of what each path would net you.

Call (305) 209-7183 · Request a review online →

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