Utilizing Nonqualified Deferred Compensation Plans to Boost Executive Benefits

Many employees consider qualified retirement plans, such as an employer 401(k) plan, a vital component of their financial future. However, for highly compensated executives (HCEs), these plans sometimes fall short in providing adequate retirement income. Nonqualified Deferred Compensation (NQDC) plans offer an alternative solution, allowing for pre-tax income deferral beyond the limits set by qualified plans. In this article, Meghan Hannon, CRPS®, explores the advantages and intricacies of NQDC plans and how implementation can round out a company’s employee benefit offerings.

What is an NQDC Plan and How Does it Work?

Unlike traditional employer 401(k) plans, NQDC plans permit participants to defer compensation on a pre-tax basis, irrespective of IRS qualified plan limits. These plans are designed for a select group of employees, typically management personnel or HCEs. Participants can also schedule deferred payments for the future, providing a flexible savings tool. Oftentimes, participants are in a different tax bracket upon retirement, meaning their deferred payments are levied at a lower tax rate than during employment.
NQDC plans can also be a cost-effective means to enhance an overall benefits package, from both the participant and employer perspective. Key among the benefits for participants are the ability to reduce current tax liability, save for short- and long-term goals, and exceed IRS 401(k) contribution limits. Meanwhile, employers offering NQDC plans can benefit from limited participation and exemption from the eligibility and nondiscrimination rules that apply to employer 401(k) plans. Their contributions can also be made on a tax-deferred basis, with earnings assessed at a future date.

Types of NQDC Plans

The most common NQDC plans are Top Hat plans, Excess Benefit plans, and Salary Reduction and Bonus Deferral plans. The “Top Hat” group typically refers to HCEs, as employees in the highest percentile of compensation. While Top Hat and Excess Benefit plans are usually funded by employers for their HCEs, Salary Reduction and Bonus Deferral plans rely on employee contributions. Some NQDC plans may also include employment agreements, equity awards, and reimbursement agreements.

Differences Between NQDC and 401(k) Plans

While NQDC plans might seem similar to an employer 401(k) plan from a participant’s perspective, they are governed by distinct rules under IRC Section 409A. 409A imposes restrictions on deferral elections and distribution timing to prevent potential tax abuse. Unlike 401(k) plans, NQDC plan participants must make deferral elections in the year preceding the service year and cannot change the election without waiting at least 12 months. Distributions are only permitted upon separation from service, death, disability, a specified date, or in the case of an unforeseeable emergency.

Funding for NQDC Plans

409A requires that NQDC plans remain unfunded, but assets may be informally maintained in a rabbi trust. This trust safeguards assets from misuse by employers but does not shield them from general creditors. Employers have various funding options, including pay-as-you-go, taxable separate investment accounts, corporate-owned life insurance (COLI), and trust-owned life insurance (TOLI).

Tax Considerations and Reporting Responsibilities

Contributions and earnings within NQDC plans accumulate on a tax-deferred basis. However, FICA and FUTA taxes apply to participant deferrals, and employer contributions are subject to these taxes upon vesting. Federal and state income taxes are incurred when amounts are distributed from the plan. Furthermore, NQDC plans must file an annual Form 5500 or a registration statement with the Department of Labor (DOL). Failure to file the registration statement can be corrected under the DOL’s Delinquent Filer Voluntary Compliance (DFVC) Program, and securities registration requirements may apply.

Helping You Get There…

Adding NQDC plans to compliment an employer 401(k) plan offers HCEs a unique opportunity for tax-deferred savings and greater financial flexibility. Despite certain limitations compared to qualified plans, NQDC plans are gaining popularity due to changing retirement and tax proposals. As individual tax rates rise, executives may seek additional tax-deferred savings options. Offering these plans can address this need and potentially offset lost deferral opportunities in qualified retirement plans.

It’s critical to consult with a trusted retirement plan advisor when considering implementation of an NQDC plan, as the rules can be complex and the specifics of each plan may vary depending on the employer’s unique circumstances. Additionally, a tax-focused advisor keeps you informed about current regulations and changing tax laws which may impact your plan. Connect with a Boulay advisor today to explore suitable additions to your organization’s benefits offering.