Nonqualified Deferred Compensation Plans
Each year some companies have a special 30-day election period for certain employees to participate in a benefit known as a nonqualified deferred compensation plan (NQDC). I was recently helping an executive with a major manufacturing firm navigate his NQDC and he had a lot of good questions. A NQDC has some attractive tax benefits for deferring compensation and participation does not affect the amount of money he can save in his 401(k) plan thus allowing him to save much more money for the future than using the 401(k) alone. By working closely with his CPA, we were able to help him make the best decision for him and his family. Following is some additional information about this attractive but sometimes confusing plan. I recommend you consult with your financial advisor and CPA to help make the decision that is right for you. I invite you to give me a call if I can assist in any way.
What is it?
A nonqualified deferred compensation (NQDC) plan is an arrangement between an employer and employee that defers the receipt of currently earned compensation. A NQDC plan doesn't need to comply with the discrimination and administrative rules that govern qualified plans, such as Section 401 of the Internal Revenue Code. And if the NQDC plan is "unfunded" (most are) the plan avoids the burdensome requirements of the Employee Retirement Income Security Act of 1974 (ERISA). Since an NQDC plan doesn't have to comply with these regulatory requirements, it's a flexible form of employee compensation that allows your employer to tailor the benefit amounts, payment terms, and conditions of the plan to your needs. In addition to its flexibility, an unfunded NQDC plan can provide you with significant tax benefits: Unlike cash compensation, which the IRS taxes currently, deferred compensation generally isn't subject to federal income taxes until you begin receiving distributions from the NQDC plan.
Funded versus unfunded plans
It is important for you to understand whether your employer's NQDC plan is "funded" or "unfunded" in order to understand how the federal tax laws and ERISA apply to the plan. Most NQDC plans are unfunded. The reason is that employers usually adopt NQDC plans in order to provide their employees with the benefit of tax deferral while at the same time avoiding the often burdensome requirements of ERISA.
Tip: ERISA does not apply if your employer is a church or a state or local government. If you're employed by a state or local government your NQDC plan is subject to a special set of rules under IRC Section 457, and this article does not generally apply.
An unfunded plan avoids most ERISA requirements, and your benefits are usually not subject to federal income tax until you receive them. A NQDC plan is unfunded if either assets have not been set aside by your employer to pay plan benefits (that is, your employer pays benefits from its general assets on a "pay as you go" basis), or assets have been set aside but those assets remain subject to the claims of your employer's creditors (often referred to as an "informally funded" plan). In general, when a plan is unfunded you must rely solely on your employer's unsecured promise to pay benefits at a later date. As a result, you may be fearful that when it comes time for you to receive the deferred compensation, your employer may be unwilling or unable to pay the deferred compensation or that a creditor may seize the funds through foreclosure, bankruptcy, or litigation. Unfunded plans must generally be limited to a select group of management or highly compensated employees, and are often called "top-hat" plans.
Tip: Although there is no formal legal definition of "select group of management or highly compensated employees," it generally means a small percentage of the employee population who are key management employees or earning a salary substantially higher than the average salary for all management employees. Generally, courts will look at the number of employees in the firm versus the number of employees covered under the top-hat plan, the average salaries of the select group versus the average salaries of other employees, and the extent to which the select group can negotiate salary and compensation packages.
If you fear losing your deferred compensation benefits (for example, if your employer becomes insolvent or declares bankruptcy) your employer may want to consider offering a funded NQDC plan. These are unusual, because funded NQDC plans generally must comply with all of ERISA's requirements, and your plan benefits are subject to federal income tax as soon as they are vested. In general, a plan is considered "funded" if assets have been irrevocably set aside with a third party (for example, in a trust) by your employer for the payment of your NQDC plan benefits, and those assets are beyond the reach of your employer and your employer's creditors. In other words, if you are guaranteed to receive your benefits under the NQDC plan, the plan is considered funded. This is also sometimes referred to as "formal funding." One of the most common methods of formally funding a NQDC plan is the secular trust. But again, unfunded plans are far more common than funded plans.
Informally funded plans
While most employers want to avoid formally funding their NQDC plans in order to avoid ERISA while providing the benefit of tax deferral, employers often want to accumulate assets in order to ensure they can meet their benefit obligations when they come due. This is called 'informally funding" a NQDC plan. Even though your employer sets aside funds, the NQDC plan is not considered formally funded because the assets remain part of your employer's general assets, and can be reached by your employer's creditors. Informal funding allows your employer to match assets to future benefit liabilities, and provides you with psychological assurance (at least) that your benefits will be paid when due. The most common method of informally funding a NQDC plan is the rabbi trust, discussed more fully below. An irrevocable rabbi trust, adequately funded, can provide you with the assurance that your benefits will be paid in all events other than the insolvency or bankruptcy of your employer.
Tax treatment--unfunded plan
Any amount your employer promises to pay you from an unfunded NQDC plan is generally not subject to federal income tax until you actually receive payment of your benefits from the plan. This is true whether or not your employer chooses to informally fund the NQDC plan (for example, through contributions to a rabbi trust). However, there are instances in which your NQDC plan benefits may be taxed prior to your actual receipt of the funds.
Under the doctrine of constructive receipt, the IRS can tax you prior to your "hands-on" receipt of funds if the funds are credited to your account, set aside, or otherwise made available to you without substantial restriction. In other words, once the funds have been earned and are payable to you on demand, you must report the income even if you choose not to actually accept current payment of the funds. The constructive receipt doctrine has been codified in part by Internal Revenue Code (IRC) Section 409A.
Section 409A of the Internal Revenue Code
IRC Section 409A provides specific rules relating to deferral elections, distributions, and funding that apply to most NQDC plans. If your employer's NQDC plan fails to follow these rules, your NQDC plan benefits for that year and all prior years may become immediately taxable, and subject to penalties and interest charges. It is very important that your employer be aware of, and follow the rules in, IRC Section 409A, when establishing a NQDC plan.
Tax treatment-- funded plan
Your employer's contributions to a funded NQDC plan are generally taxable to you once you become vested in the contributions--that is, when the benefits are no longer subject to a substantial risk of forfeiture. This is true even if you don't yet have a right to receive payment from the plan. If the plan is funded with a secular trust you may be entitled to a distribution from the trust to pay the taxes. Or your employer may decide to pay you a cash bonus that covers your tax liability. The tax treatment of benefits paid from a NQDC plan funded with a secular trust can be quite complex.
NQDC plan issues that concern key employees
Dollar limitations on contributions to and benefits payable from qualified plans
Sometimes, highly compensated employees are adversely affected by the dollar limitations on contributions to and benefits payable from qualified plans. As a result, they don't receive as high a percentage of their compensation as do lower-paid employees under a qualified plan. A NQDC plan can help solve this problem.
Tip: The compensation limit (which is indexed for inflation) is $265,000 for 2016 (unchanged from 2015).
Example(s): Hal and Jane work at BCD Corporation. Hal earns $300,000 in 2016, while Jane earns $100,000. They both participate in a defined benefit plan that provides a general benefit of 50 percent of salary. Although the plan formula dictates that Hal should get a benefit of $150,000 (50 percent of $300,000), he actually is only allowed to receive $132,500 (50 percent of $265,000) because $265,000 is the maximum compensation amount that may be used in calculating the benefit in 2016. Conversely, Jane is entitled to $50,000 (50 percent of $100,000) because her entire annual salary can be taken into account, since it is below $265,000. As a result, Hal may only receive approximately 44.2 percent of his pay, while Jane may receive the 50 percent as dictated by the plan formula. Hal is adversely impacted by the $265,000 maximum, while Jane isn't.
Generally, a key employee is subject to a higher income tax rate. As a result, a key employee can benefit from deferring compensation, since he or she is likely to be in a lower tax bracket during retirement, when the deferred compensation is finally received.
Example(s): Hal works at XYZ Company. Hal is given the option of receiving as earned or deferring until retirement a $100,000 bonus. His current marginal tax rate is 35 percent, and his estimated marginal tax rate at retirement will be 25 percent. Assuming no other variables, if Hal decides to receive the $100,000 bonus this year, he will be taxed $35,000 (35 percent of $100,000), but if he defers the income until retirement, he will only be taxed $25,000 (25 percent of $100,000).
While believed to be accurate and from sources deemed to be reliable, the presented information is general in nature. It is not intended to provide, and should not be relied on for, accounting, investment, legal or tax advice. Consult the appropriate professional advisor for more complete and current information. Investors should consider their individual financial circumstances and the inherent risks of investing with their investment advisor. Services provided by Wealth Management located at Bank of the Bluegrass & Trust Co.: Are not FDIC insured*Are not bank guaranteed*May lose value*Are not guaranteed by any state or government agency. Prepared by Broadridge Investor Communication Solutions, Inc. Copyright 2016.