Offering This Benefit Can Help You Attract and Retain Key Talent — But Here’s What You Should Know First
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A nonqualified deferred compensation (NQDC) plan is a great way for employers to attract and retain key talent. It also represents a potentially massive tax savings opportunity for highly compensated employees. There is a lot that you need to know about these plans before deciding to participate in one, however. So, let’s get into the basics.
A nonqualified deferred compensation (NQDC) plan allows employees to earn their pay, potential bonuses and other forms of compensation in one year but receive those earnings in a future year. This also defers the income tax on the compensation. It helps provide income for the future, and there’s a possibility for a reduced amount of income tax payable if the employee is in a lower tax bracket at the time of the deferred payment.
It’s worth noting that tax law requires these NQDC plans to be in writing. There needs to be documentation about the amount being paid, the payment schedule and what the future triggering event will be for compensation to be paid out. There also needs to be an assertion from the employee of their intent to defer the compensation beyond the year.
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A NQDC plan is a contractual fringe benefit often included as part of an overall compensation package for key executives. It can serve as an important supplement to traditional retirement savings tools, such as individual retirement accounts — IRA and 401(k) plans.
Like a 401(k), you can defer compensation into the plan, defer taxes on any earnings until you make withdrawals in the future and designate beneficiaries. Unlike a 401(k) plan or traditional IRA, there are no contribution limits for an NQDC — although your employer can set its own limits. Therefore, you can potentially defer up to all your annual bonuses to supplement your retirement. We have seen companies allow you to defer as much as 25-50% of your base salary as well.
Employers: Take note
NQDC plans carry some benefits for employers as well. The plans are a low-cost endeavor. After initial legal and accounting fees, there are no annual payments required. There are no unnecessary filings with government agencies like the Internal Revenue Service.
Since the plans are not qualified, they are not covered under the Employee Retirement Income Security Act (ERISA). This provides a greater amount of flexibility for both employers and employees. Employers can offer NQDC plans to select executives and employees who would benefit the most from them.
Companies can customize plans toward valued members of their workforce, creating incentives for these employees to remain with the company. For example, an employee’s deferred benefits could be rendered forfeit if said employee decides to leave the company before retirement. We call this strategy a “golden handcuffs” approach.
Related: Why Good Employees Leave — and What You Can do About It
Employees: Take note
For highly compensated employees, social security and 401(k) can only replace so much of your income in retirement. You could potentially build up the bulk of your retirement savings with your NQDC plan. There’s also the bonus of reducing your annual taxable income by deferring your compensation. This brings into play the idea of being in a lower tax bracket, decreasing the amount of taxes you would need to pay. Many employers even incentivize this, offering a match of some kind.
Timing of payment
The timing of when you take NQDC distributions is important since you’ll need to project your potential cash flow needs and tax liabilities far into the future.
Deferred compensation plans require you to make an upfront election of when you will receive the funds. For example, you might time the payments to come at retirement or when a child is entering college. In addition, the funds could come all at once or in a series of payments. There is tremendous flexibility often in these plans.
Taking a lump-sum payment gives you immediate access to your money upon the distributable event (often retirement or separation of service). While you will be free to invest or spend the money as you wish, you will owe regular income taxes on the entire lump sum and lose the benefit of tax-deferred compounding. If you elect to take the money in installments, the remainder can continue to grow tax-deferred, and you’ll spread out your tax bill over several years.
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An NQDC plan does come with some risks. When you participate in a qualified plan, your assets are segregated from company assets, and 100% of your contributions belong to you. Because a Section 409A plan is nonqualified, your assets are tied to your employer’s general assets. In case of bankruptcy, employees with deferrals become unsecured creditors of the company and must line up behind secured creditors in the hopes of getting paid.
Thus, you should consider how much of your wealth — including salary, bonus, stock options and restricted stock — is already tied to the future health and success of one company. Adding deferred compensation exposure may cause you to take on more risk than is appropriate for your personal situation.
Before you choose to participate in an NQDC plan, you should speak with both your financial advisor and your tax professional. You really want to model out how and when you will receive these disbursements. Ideally, you are planning with enough foresight that you will offset this income tax event in retirement with withdrawals from a brokerage account or a Roth IRA or 401(k). You will also want to pay attention to the impact of high income with the taxation of Medicare Part B — if you think there are a lot of moving parts here, you are right! When executed properly, you can truly develop a unique plan that is customized to your exact living situation and future goals.
Any discussion of taxes is for general informational purposes only, does not purport to be complete or cover every situation, and should not be construed as legal, tax or accounting advice. Clients should confer with their qualified legal, tax and accounting advisors as appropriate.
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