Non-Qualified Deferred Compensation Plan Considerations
Non-Qualified ("NQ") plans can be great retention tools for executive talent
NQ plans offer significant savings and tax management opportunities
Participants need to apply careful cash flow and asset protection considerations
Non-Qualified Deferred Compensation (“NQ”) plans, also referred to as 457 Plans, are different than the more common, qualified employer retirement plan offerings, like 401(k) and 403(b) plans, because NQ plans are offered only to executive-level employees and do not need to comply with the Employee Retirement Income Security Act (ERISA).
Many organizations offer NQ plans as an executive benefit to attract and retain talent and key leadership members because the qualified plan limits do not allow highly paid executives to save enough for their retirement needs.
While an NQ plan can provide a way to save substantial amounts, it’s important to understand the plan’s advantages and limitations to determine whether this plan is right for you.
NQDC Plan – Advantages
If you are maxing out your qualified plan, HSA, and IRAs and still looking for other ways to save on a tax-friendly basis, then a NQ plan offered by your employer may be your next option. Unlike the qualified plans that have annual deferral limits of $19,500 ($26,000 if you’re at least 50 years old) in 2020, you can defer up to $1 million a year in most NQ plans.
Similar to traditional and rollover IRAs, the advantage of deferring a significant amount of income is to reduce your current exposure to high tax rates and take distributions when your income is expected to be subject to lower tax rates. If you are currently exposed to the alternative minimum tax (“AMT”), then a NQ plan may increase your ability to claim other tax deductions.
While these deferrals are not subject to income taxes until they are distributed, they are still subject to Social Security and Medicare taxes.
NQDC Plan – Limitations
Although generous contribution limits can help you manage your current tax liability, you lose a lot of flexibility and control when contributing to a NQ plan.
While some qualified plans, like a 401(k) plan, will allow for early distributions due to certain financial hardships and can be borrowed against in most cases, NQ plans only allow distributions at the specific time you indicated upon enrollment. Most NQ plans, however, do allow for non-retirement distributions provided that these distributions were accounted for upon enrollment. For example, if you want to defer your compensation in anticipation of college tuition payments or a summer home purchase, then you can account for those goals with your NQ plan.
It is very common for 401(k) plans to allow participants to change their contribution elections regularly. For example, if you started the year contributing 10% to your plan, but you had some unexpected cash-flow events came up, then you can decrease your contributions in May.
NQ plans do not offer the same flexibility as qualified plans because you cannot change your contribution elections throughout the year. Typically, contributions elections are made annually so very thoughtful cash flow planning should be applied before making that election.
Even more careful planning is needed for making distribution elections because distribution elections are made upon enrolling in the plan and are irrevocable. For example, if you request distributions to begin in 10 years, then they begin in 10 years regardless of what may have changed in your life since making that election.
The most important difference between qualified plans and NQ plans is creditor protection. While qualified plans’ assets are separated for each employee and not part of the employer’s general assets, a NQ plan is an informal plan structure and is kept as a general asset of your employer. Essentially, a NQ plan is an employer’s promise to pay you back, so these are assets that would be subject to a creditor’s claim in the event of bankruptcy.
While this risk is certainly a consideration, an executive team likely wouldn’t make a NQ plan available, let alone make contributions to it, when the organization is not in very stable financial condition.
While NQ plans offer a meaningful way to manage tax exposure, the limitations on changing elections and differences in asset protection are key considerations to discuss with your financial advisor and tax professional to determine whether participation in the plan makes sense for you.
Kick start your conversation with these questions.
Have I maxed out other retirement savings plans?
Do I need to save more for non-retirement expenses?
What will my income tax exposure look like when these funds are distributed?
Can I afford to lose my contributions?
Frank Iozzo, CPWA®
President, Private Wealth Advisor
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