Nonqualified Deferred Compensation Assets - How Risky Are They Really?
High-income earners naturally look to maintain their standard of living post-retirement, but government-sponsored retirement plans are not typically geared to offer protection to this class of individuals. At least, not in tax-efficient ways.
Private deferred compensation plans have been used as retirement-planning vehicles for executives and other professionals for decades, with varying success. How do they work, and how can participants mitigate their risks?
What Are Nonqualifying Deferred Compensation Plans (NQDCs)?
NQDCs are agreements between employees and employers. The parties agree to defer payment of part of the employees’ compensation to a future date. In doing so, the payment of tax is also deferred. This may have the effect of lowering the employee’s current tax bracket. If the compensation payment is delayed to retirement, it too will fall into a lower tax bracket because the employee is no longer earning.
In the interim, the gross compensation amount can be invested for the employee’s benefit, as opposed to the after-tax amount that would be available if the employee was paid upfront.
What Made the Establishment of NQDCs Necessary?
Government-sponsored qualified retirement savings plans, like 401(k)s, also defer compensation and provide tax-free investments. However, there are caps on the contributions to these funds. This disadvantages high-income earners because they cannot save proportionately to low-income earners.
NQDCs were therefore created to give high-income earners additional tax-deferred investment growth. The plans are commonly used to attract, retain, and reward top executive talent. They are also becoming more prevalent in the small business sector.
What Is the Difference between Qualified and Nonqualified Deferred Compensation?
NQDCs do not qualify for regulation by the Employee Retirement Income Security Act (ERISA). ERISA was enacted in 1974 to protect workers against abuse of retirement and health funds by employers. It requires funds to be kept in a trust account, which cannot be accessed by creditors should the company fail to pay its debts.
The law also stipulates limits to fund contributions, the minimum criteria for employee qualification, and how the employer needs to ensure funding. Also, it ensures that employees have gratis and full access to information about their funds.
In contrast, NQDCs have no contribution thresholds. They can be offered to employees at the employer's discretion and are not subject to the same governance requirements as ERISA-qualifying funds. However, NQDC assets are not protected from creditors in the event of bankruptcy.
Using Rabbi Trusts to Secure NQDCs
One way to protect NQDC assets is to administer them within a “rabbi trust.” A rabbi trust is an irrevocable trust codified by the IRS in 1992 for use as a benefit security device. The name originates from a case ruling that a trust established for a rabbi by his congregation was not subject to current income taxation of the assets.
A rabbi trust protects any assets deposited into it from “corporate change of control, management’s change of heart, or changes in the financial condition of the company, short of bankruptcy.” It protects employees by ensuring the company cannot use deposited funds for anything other than to pay the NQDC’s benefits. However, it does not protect employees from creditors if the company goes bankrupt.
How Does Section 409A Impact NQDC Risk?
Before the adoption of Section 409A in 2005, most NQDCs had “haircut provisions.” These provisions gave participants the right to withdraw their funds at any time, subject to a 10 percent penalty (the haircut). As participants were typically company executives, this substantially reduced their risk. The minute they became aware of the company having financial troubles, they could exercise their option to withdraw their funds.
However, Section 409A now limits participant control. It does away with haircut provision and increases restrictions on the deferral and withdrawal of NQDCs. Initially, participants needed to incur an unforeseeable emergency or disability as defined in the Internal Revenue Code to withdraw funds early. However, in 2020, the IRS made available a third option for cancellation: the receipt of a coronavirus-related distribution (CRD).
Can the Risk of Bankruptcy Be Mitigated?
As a result of 409A, executives have resorted to lump-sum payments that nullify any tax advantage or defer less compensation than they might otherwise choose to.
In some cases, secular (or vested) trusts in employees’ names are set up outside of the company in such a way that creditors can't access the funds. However, to avoid employees having to pay tax on the trust income, the employer must be the grantor. Any withdrawals by the employees have to be severely restricted. If not worded correctly, employees can be taxed on the deposits and, again, on the withdrawals.
Deferred compensation protection trusts (DCPTs), developed by Los Angeles-based StockShield, potentially offer a less traditional way to spread bankruptcy risk. For example, 20 participants with NQDC assets in different companies in different industries pool small cash deposits (1 percent each year for a minimum of five years, for example). The cash is invested in US Treasury Securities and paid out according to the number of bankruptcies at the end of the term. If there are no bankruptcies, all pooled cash is refunded (the yield covers administrative expenses). Pooled risk DCPTs can protect against significant losses and can be an affordable option to the tax on lump-sum payments.
When Should NQDCs be Considered?
Before considering an NQDC, you should first maximize your 401(k) plan and HSA (if applicable). After that, you should evaluate how much and how long you can afford to defer, keeping in mind that deferral is most effective when timed with a lower tax bracket, like retirement.
The flexibility of distributions and the investment options of the plan should also be considered. Do distributions align with your life goals, such as paying for a child’s college education? Also, will the investments offer adequate growth? Finally, how financially secure is the employer, and are you in a position to absorb the risk of losing your NQDC assets?
A qualified financial planner will be able to discuss and advise on the suitability of NQDCs based on your profile.
