The Pro’s & Con’s of Non-Qualified Deferred Compensation
Retirement savings options have expanded dramatically over the last four decades across the United States. Defined contribution plans such as 401k’s have progressively become the primary source of private sector savings since the early 1980’s. Unfortunately, for those in a higher income range annual dollar value caps associated with contributions are imposed. In 2014, the maximum annual salary deferral for an employee is $17,500.00 ($23,000.00 if over age 50). One alternative solution to help mitigate tax liability is the use of the Non-Qualified Deferred Compensation Plan (NQDC).
A NQDC plan is something which can be established by a small business owner or by a large fortune 500 company, and falls outside the regulatory scope of the Employee Retirement Income Security Act (ERISA). Under a NQDC plan, contributions made to the plan by an employee are deferred income which may be salary, bonus, commissions etc. These contributions can often permit as much as 50% of an individual’s compensation. In making the salary deferral contribution, the employee reduces their Adjusted Gross Income (AGI). This not only lowers taxable wages, but also may reduce an individual’s exposure to the Alternative Minimum Tax (AMT). By reducing AMT there may be additional tax benefits such as increasing the availability of itemized deductions like mortgage interest and property taxes.
These plans are typically account based or non-account based plans. The contributions to account based plans may be met with a company match, and earn a fixed or variable interest rate. Some plans will opt to offer various investment options not unlike a 401k plan. Under a non-account based plan, the benefits function similar to a defined benefit plan…which is similar to a pension plan providing an annual lifetime income at the commencement of benefits.
In the case of a small business owner, due to the greater flexibility of plan participation resulting from operating outside of ERISA laws...they can offer the plan to only key employees. This can greatly reduce the administrative and funding liability, while offering the small business owner significant tax advantages. However, since the plan is not income to the employee, the plan does not become a deduction for the business until benefits commence. Due to the lack of an immediate tax benefit to the employer, many of these plans are unfunded future obligations.
While there can be substantial immediate tax benefits to an employee contributing dollars to a NQDC plan, there are inherent disadvantages. Among those disadvantages would be that the plan is a liability of the corporation and subject to the general creditors of the company. This is in contrast to a qualified plan in which vested plan assets belong exclusively to the employee. As a result of this liability, some employers have purchased insurance to help cover the liability of the plan should a company be liquidated. However, this benefit is the same as that of a general creditor and does not guarantee that the insurance will be sufficient to meet the unfunded liability. So when an employee opts to contribute deferred income, they should seriously consider the long term fiscal health of the employer. This becomes difficult for a younger employee who may be affiliated with a prosperous company, but couldn’t possibly forecast with any certainty the fiscal health of an organization in 20 years. It is possible that some or all of your salary deferral saved over many years would be confiscated by creditors of the company.
Some plans are established as funded plans, such as a Rabbi Trust. Under this type of trust, the plan assets are segregated in a separate trust for the purpose of satisfying future plan benefits. Ordinarily, this would make the income taxable to the employee. However, the IRS has permitted this as a funded NQDC plan presuming that the trust is subject to substantial risk of forfeiture by including the trust as an asset that can be claimed by the general creditors of the corporation.
Another issue to be concerned with as a possible participant in a NQDC plan is that of the timing of distributions. NQDC plans are not eligible to be rolled into an IRA/401k or any other qualified plan at retirement or separation from service. This lack of portability means more restrictions on benefit distributions. These restrictions have been increased substantially since 2005 with the passing of the 409a legislation. These rules were designed to prevent key employees from accelerating benefits and liquidating plan assets in advance of a financial liquidation of a company in fiscal trouble. Any failure to comply with the 409a rules would result in substantial IRS penalties. The rules of 409a restrict distributions to several categories. Among them are…separation from service, death, disability, fixed time frame, change in ownership of the company.
It is important as the employee to understand these restrictions. As an example, if the plan was designed to be paid out over a five year period following separation from service, this could become problematic if you just resigned your position in order to accept a better job with a higher salary at a new company. In theory, you may have deferred income for only a few years only to realize it long before retirement while still in a high/higher tax bracket. This would have totally negated the tax benefit. As such, it is important to consider these variables when determining whether or not you wish to participate or create a NQDC plan. It is advisable to discuss this with both your financial & tax advisors to ensure proper planning and suitability.
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