July 17, 2017, 5:22 AM

Why You Should Look before You Leap into Your Employer’s Nonqualified Deferred Compensation Plan

By Michael Rose, CFP®, MST

When individuals earn income it is subject to taxation. For high income earners there are very few ways to get around this truism in a material way. Of course, one can and should make the maximum allowable contribution to employer-sponsored qualified retirement plans such as 401(k) and 403(b) plans. For high income earners, though, the maximum amount that can be saved into these plans might represent only a small percentage of their total income. This leaves many of those individuals asking how they can further avoid the immediate taxation of their income. One potential answer to this question comes in the form of nonqualified deferred compensation plans (NDCPs).

While they come in many flavors and go by different names that vary by employer, all NDCPs share certain characteristics by their nature. When properly designed and implemented, these plans provide for the deferral of the receipt and taxation of earned income into some designated point in the future. To qualify for this treatment, these plans must satisfy a variety of rules laid out in Section 409A of the Internal Revenue Code and the various provisions of IRS Regulation 1.451-2, in addition to other statutory and regulatory rules.

When available to a highly compensated individual, these plans can represent a powerful way to defer income taxes and maximize the benefits of compound investment growth, much like the far more commonly available 403(b) and 401(k) plans. Because NDCPs do not adhere to the rigorous tax laws that apply to those “qualified” retirement plans, however, it is critically important to consider and understand the significant limitations of these plans to fully value the benefit of such an arrangement. Although the tax benefits of these plans should not be diminished, many executives value the benefits of these plans too highly without fully recognizing some their key restrictions.

In simple terms, a nonqualified deferred compensation plan is an arrangement in which an employer provides an employee with an unsecured promise to pay him or her, at some pre-determined time in the future, for services rendered in the current year. I like to call this the “Wimpy Principle”, named for the character in the Popeye cartoons who would “gladly pay you Tuesday, for a hamburger today”. This unsecured promise of future income is at the very heart of both the benefit of the deferral of income taxation that apply to these arrangements, and the risk that is inherent in them.

NDCPs are most often funded either by the employee making an election to defer income she would otherwise receive currently (much like a 401(k) contribution), or by contributions made entirely at the will of the employer as a form of additional compensation.

NDCPs function by taking advantage of a tax concept known as “constructive receipt,” which is codified in Section 451 of the Internal Revenue Code and further refined by IRS regulations. In simple terms, the constructive receipt doctrine stipulates that income will not be recognized for tax purposes while there remains a substantial risk of forfeiture of that income to the recipient.

To defer taxation of the earned income pursuant to the constructive receipt doctrine, NDCP arrangements must represent an unsecured promise to pay an employee at some future date. As a result, money deferred via these arrangements is at risk in the event the employer does not ultimately pay, for reasons such as bankruptcy or termination. In an attempt to help mitigate some of the risks to the employee, NDCPs may utilize what is known as a rabbi trust, an arrangement in which nonqualified tax-deferred assets are held for the benefit of participating employees. This does help protect the employee from some potential causes for an employer’s failure to pay as agreed, such as a hostile takeover of the corporation by an entity that is less inclined to pay. However, because these trusts do not protect the assets from potential creditors of the business, they do not protect the employee from the employer’s failure to pay as a result of bankruptcy, which is one of the most worrying potential outcomes. Indeed, if the assets were protected from claims against potential creditors of the business, this likely would trigger the deferred income to be characterized as constructively received, subjecting it to immediate taxation. Being somewhat shielded from events outside of the employee’s control, the use of a rabbi trust should factor into an evaluation of the strength of the agreement, but it does not by itself mitigate all forfeiture risk.

Depending on the structure of the NDCP arrangement, it is likely that many of the protections afforded to employee retirement plans by the Employee Retirement Income Security Act (ERISA) will not apply a NDCP. This is often advantageous for the employer who, as a result, is able to add restrictions to the plans’ benefits that would not otherwise be allowed. NDCP arrangements can also provide for the forfeiture of deferred income in the event the employee is terminated with cause, joins a competing company within a specific period of time, and other events.

This blog post represents only a small number of the considerations associated with NDCPs. Because of their significant potential for income tax reduction, as well as the potential risk of losing everything, NDCPs require careful consideration before they contribute to an individual’s decision to join an organization and/or to defer income that would otherwise be received presently. Therefore, it is highly advisable to speak with a professional well versed in these plans to assist in evaluating and, if appropriate, effectively making use of an employer’s nonqualified plan.

 

Disclosure: Modera Wealth Management, LLC (“Modera”) is an SEC registered investment adviser with places of business in Massachusetts, New Jersey, Florida and Georgia.  SEC registration does not imply any level of skill or training.  Modera may only transact business in those states in which it is notice filed or qualifies for an exemption or exclusion from notice filing requirements.  For information pertaining to Modera’s registration status, its fees and services and/or a copy of our Form ADV disclosure statement, please contact Modera or refer to the Investment Adviser Public Disclosure Web site (www.adviserinfo.sec.gov).  A full description of the firm’s business operations and service offerings is contained in our Disclosure Brochure which appears as Part 2A of Form ADV.  Please read the Disclosure Brochure carefully before you invest or send money.

This article contains content that is not suitable for everyone and is limited to the dissemination of general information pertaining to Modera’s financial planning, investing and wealth management services.  Past performance is no guarantee of future results, and there is no guarantee that the views and opinions expressed in this presentation will come to pass.  Nothing contained herein should be interpreted as legal, tax or accounting advice nor should it be construed as personalized financial, investing, wealth management or other advice.  For legal, tax and accounting-related matters, we recommend that you seek the advice of a qualified attorney or accountant.  This article is not a substitute for personalized planning from Modera.  The content is current only as of the date on which the presentation was given.  The statements and opinions expressed are subject to change without notice based on changes in the law and other conditio

Share this article

June 21, 2017, 12:22 PM

Health Savings Accounts (HSAs)

By Michael Gibney, CFP®, AIF®

Ever since discussion of the Affordable Care Act (ACA or Obamacare) has come to the fore, healthcare and the focus on its increasing cost have been in the news.

Years ago the cost of health insurance was low enough that as common practice many employers covered most of...

Read More