Key Points:
- Tax-Deferred Benefits: NQDC plans offer high-earning employees a way to defer income and taxes beyond traditional IRS limits.
- Flexible Investment Options: Similar to 401(k) plans, NQDCs provide a range of investment choices tailored to individual financial goals.
- No ERISA Protection: NQDC plans lack ERISA safeguards, making them susceptible to company financial risks, including bankruptcy.
- Tax Rate Arbitrage: Utilizing NQDC plans can offer strategic tax planning opportunities, aiding in financial independence.
- Consult Financial Advisors: Due to their complexity and associated risks, expert financial advice is recommended when considering NQDC plans.
Introduction
Executive’s compensation packages can be complicated and may include many different complex components. Examples of these are Restricted Stock Grants, Employee Stock Options (ESO), Non-qualified Stock Options (NSO), Incentive Stock Options (ISO), Employee Stock Purchase Plans (ESPPS), and the topic of this article: Nonqualified Deferred Compensation (NQDC) – 409A plans.
Nonqualified deferred compensation plans (NQDC) come in two main forms: top-hat plans and deferred savings plans. Top-hat plans are typically funded by employers, while deferred savings plans are based on the amount of salary or bonus deferred by each employee. Several subtypes of NQDC plans also exist, including salary reduction arrangements, bonus deferral plans, supplemental executive retirement plans (SERPs), and excess benefit plans.
The most common of these types, and the one that will be discussed here, is the deferred savings plans including salary reduction and bonus deferral arrangements.
At its core, these NQDC plans are an agreement between employers and employees for the employer to pay the employee in the future. It allows the employee to earn wages, bonuses, and other forms of compensation now but defer the income and taxation until a later date. The compensation is put into a permanent trust where it grows tax-deferred. It allows the employee to invest money for retirement, children’s college, etc without having to pay taxes on the contributions or earnings on those contributions until the money is withdrawn. Not every corporation offers NQDCs and even when they have them, they are only allowed to be offered to the “key employees.” There are several tests of who is key including percentage of total employees to the included number, salary differentials, etc but the point is that, by definition, they cannot be offered to all employees.
This post will discuss the basics of NQDC, the advantages of these plans, the risks, and how they can be used to create financial independence (freedom from the golden handcuffs).
What is a NQDC and is there risk?
At first, a NQDC sounds very similar to traditional retirement plans such as 401(k)s and IRAs since you are deferring earnings and being taxed later but it is very important to understand that, unlike a 401(k) or IRA, the money is not in an account in your name. In order for the compensation to be tax deferred, it is transferred into a “Rabbi Trust.”
A rabbi trust is a type of trust used by businesses or other entities to defer the taxability of non-qualified benefit obligations to their employees. But here is the important part: it is a company-owned trust. The fact that it is company-owned, not employee-owned, is the reason income taxes are allowed to be deferred.
Ownership, loanership, who cares? I’m not paying taxes!
Well this ownership structure creates a risk for the employee. Since the assets are company-owned, they can be claimed by creditors if the company defaults on its loans or other financial obligations. In plain english, if the company goes under, you could lose some or all of compensation (and earnings) that you have deferred.
That is quite a risk.
The second risk of the plan is much smaller, the distribution terms of the plan. NQDC plan distribution terms can vary widely but they commonly have terms that if you leave or retire from the company after a certain age (say 55) you have the option to receive the assets in the plan over 10 or 15 years. If you leave under that age, they may be distributed immediately. The risk here is that no mater the distribution terms, it could push you into a higher tax rate if you have not planned for them properly.
Benefits of NQDC
The major benefits of these plans are they provide more flexibility in terms of how much money can be invested and when it can be withdrawn than traditional retirement plans. Unlike traditional 401(k)s and IRAs, these often do not have limits on the amount of compensation that can be deferred.
This allows the executive to defer the maximum IRS allowed amount into a traditional plan like a 401(k) and then defer even more into the NQDC plan.
Investment options are often similar to the companies 401(k) menu options, and amounts deferred can be invested and continue to grow tax deferred according to their individual needs and goals. Having increased pretax assets at retirement or reaching financial independence is especially useful for executives that plan to reach that point younger than traditional retirees, and will enjoy a long tax planning window. This allows more tax arbitrage opportunities to pay lower lifetime taxes.
Should I participate?
Non-Qualified Deferred Compensation plans offer executives many advantages, including the potential for financial independence, tax advantages, and more flexibility in terms of how much money can be invested and when it can be withdrawn but do the risks outweigh the benefits?
The company specific risk inherent in NQDC plans is very real and needs to be considered. The first step in that consideration has to be objectively looking at the financial health and business outlook for your company. That sounds a lot easier than it is when you work at the company and your life is so intertwined with its operation. I would recommend reading as much outside reporting on your company as possible. If it is publicly traded, that can be easier since there may be third party analyst reports on the company.
If you have done that and you are still comfortable, the next step is to consider the assets in the NQDC plan as you would with a high concentration in any asset and try to limit it to a percentage of your total net worth.
There are several ways to do that. First is once your balance in the plan reaches a certain level, consider suspending contributions.
The second is to evaluate the plan distribution options. Some plans allow distributions while employed but after the contributions have been invested for a certain period of time, say five years. This can allow future distributions around future events like your children going to college. This can help you fund those future financial goals and keep your NQDC plan balance under your targeted percentage of net worth. The only risk is that it could push you into a higher tax bracket in the year of distribution.
Non-Qualified Deferred Compensation Plans, just like many aspects of executive compensation can quickly become complex when being incorporated into a lifelong financial plan but through planning it can be a useful tool in lowering lifetime taxes paid. If you have any questions or need help navigating this or any part of your executive comp plan, please leave a question or reach out to us.
Finding your purpose is a journey, not a destination. It’s something that you’ll continue to discover throughout your life. But it’s a journey that’s worth taking. So don’t be afraid to start exploring today. Purpose Built Financial Services can help you along the way.
Frequently Asked Questions
What is Non-Qualified Deferred Compensation (NQDC)?
Non-Qualified Deferred Compensation (NQDC) is a type of retirement plan that allows highly compensated employees to defer income and taxation to a future date. Unlike traditional 401(k) plans, NQDCs offer more flexibility in terms of contribution limits and withdrawal options.
What are 409A Plans?
409A Plans are a specific type of NQDC regulated under Section 409A of the Internal Revenue Code. They allow for the deferral of compensation beyond the limits set by traditional retirement plans.
How do NQDCs differ from traditional retirement plans?
NQDCs offer more flexibility in terms of contribution limits and withdrawal options. However, they do not offer the same level of protection as ERISA-governed plans, making them riskier in certain scenarios.
What are the benefits of NQDC plans?
NQDC plans offer tax-deferred growth, flexibility in investment options, and the ability to defer income beyond IRS limits. They can be particularly beneficial for executives aiming for early financial independence.
What are the risks associated with NQDC plans?
The primary risks include the lack of ERISA protection and the potential for loss if the company faces financial difficulties. It’s crucial to assess the financial stability of your employer before opting for an NQDC plan.
What is a Rabbi Trust?
A Rabbi Trust is a company-owned trust where deferred compensation is stored. It allows for tax deferral but also exposes the assets to company creditors.
How can I mitigate the risks of NQDC plans?
To mitigate risks, consider the financial health of your company, diversify your investment portfolio, and consult with a financial advisor experienced in executive compensation planning.
Should I participate in an NQDC plan?
Participation should be based on your individual financial goals, the stability of your employer, and your comfort level with the associated risks. Consult a financial advisor for personalized guidance.
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