This article appears in Charlotte Business Journal.
As a top executive in your company, your salary package includes both a base salary and deferred compensation, which is compensation that is set aside to be paid later. There are two types of deferred compensation: qualified deferred compensation (QDC) and non-qualified deferred compensation (NQDC). Qualified deferred compensation plans are pension plans governed by the Employee Retirement Income Security Act (ERISA). These can include 401(k) and 403(b) plans. Non-qualified deferred compensation (NQDC) plans are plans offered to especially valuable employees as a way to retain them. There are generally no caps on contributions. Below are a few things it can be helpful to be mindful of with the different types of deferred compensation.
1. The Potential for Increased After-Tax Benefits
The compounding effect of your pre-tax dollars could leave you with a higher pre-tax balance and higher taxes. But most importantly, a higher after-tax balance. Assuming your tax rate is the same or lower at the time of deferral and distribution, the after-tax proceeds using the NQDC are 38% higher for 10 years and 56% higher for 15 years.
2. Potential for Income Tax Arbitrage
In addition to the potential earnings on pre-tax dollars, by planning distributions in years when your potential tax liability will be lower, you could be able to pick up some additional after-tax dollars compared to your current tax of your earned income.
3. Investment Options
The majority of NQDC plans offer investment choices similar to 401(k) plans. However, there can be some unique options with guarantees tied to certain benchmarks or fixed rates that can’t be found in 401(k) plans. Some NQDC plans allow executives to defer certain equity awards and hold the shares in the deferred compensation plans. There may be potential restrictions on selling the company’s stock.
4. Fewer IRS Limitations
There are no regulatory limitations on income or contributions to NQDC plans. Currently, qualified plans are capped at $305,000; employee contributions are capped at $20,500 a year, plus an additional $6,500 for employees over age 50. Some plans will have an employer match similar to their 401(k). While it often makes sense to maximize the 401(k) first, the lack of IRS limitations can make participation in NQDC plans attractive.
5. Defined and More Restrictive Distribution Rules
Unlike a 401(k) plan that allows you to roll over or pull out the funds at will after retirement, NQDC plans have more restrictive distribution rules. For example, Section 419 of Title 26 of the USC does not allow changes to the election within 12 months of the planned distribution. If you choose an NQDC distribution(s) at separation but leave the company sooner due to a new job offer or forced retirement, the funds will be paid out based on your initial election. Any changes in the deferral elections must extend five years beyond the original distribution start date.
6. Limited Early Withdrawal Provisions
Unlike a 401(k), there are no loan provisions in an NQDC plan. You can petition for hardship withdrawals from the NQDC plan, but you’re otherwise restricted from accessing the funds, aside from the planned distributions.
7. Forfeiture Risk
Forfeiture provisions can be found in NQDC plans. Companies may apply vesting schedules such as the language of forfeiture with non-compete provisions, leaving in un-amicable circumstances, or other “golden handcuffs” language that effectively binds you to the organization.
8. Creditor Risk
Unlike a 401(k) or other qualified plans, if a company files for bankruptcy, the plan’s assets are subject to creditor claims. The deferred compensation plan dollars are considered assets of the company. One possible solution is to set up a Rabbi Trust to protect the assets from the company, but it does not protect them from creditors. It’s important to weigh this risk relative to the current environment and to future risks such as company debt load, market competition, consumer preferences, technology, regulatory, and other geopolitical risks. With that said, funds are not at risk once paid to you, so you should consider the length of the payout, too.
As you can see, there are many variations of deferred compensation plans, and any two are rarely alike. It’s important to read plan documents carefully to avoid surprises and to factor various scenarios into planning as they could materially change the intended outcome.
Interested in learning more about deferred compensation? Contact SignatureExecutive for help, dan.dubay@signaturefd.com.
