Why a Nonqualified Deferred Compensation Plan May be Right for You

Would you be surprised to know that a nonqualified deferred compensation plan (“NQDCP”) could enable your senior managers to replace a higher proportion of their current income when they retire? While NQDCPs are typically viewed as an option for top executives, they may also be right for your upper-level staff.

Some Considerations

The issue boils down to compensation levels for senior management, along with their willingness to set aside current income for future use. NQDCPs might make sense when enough employees are prepared to defer more of their income than is allowed in a 401(k) plan. Determining whether there would be enough participation requires an assessment of how motivational this program could be for prospective participants, along with the administrative costs involved.

Important note to consider: compensation deferred in a NQDCP isn’t segregated from general corporate assets. Rather, it’s a number on the balance sheet and is subject to the substantial risk of forfeiture. If the company becomes insolvent, NQDCP participants will be waiting in line, along with other creditors to claim benefits, if any.

Key Features

So what are some NQDCP rules? Here are some key features to be aware of with this type of plan:

You decide who’s eligible. NQDCPs aren’t subject to antidiscrimination rules, so you can limit participation to the highest earners. In practice, these plans aren’t available to rank-and-file employees who don’t fall within the definition of a select group of senior management.

You can attach strings. Employers can establish certain rules and circumstances under which employees must forfeit accumulated NQDCP funds. For example, if an employee is terminated for cause, or an employee resigns and accepts a position with a competitor, the plan can specify that the employee must forfeit NQDCP funds. You can also establish vesting requirements, as you can in a qualified plan.

You can grant flexibility. These plans don’t have to be used only for retirement savings purposes. For example, employees can take “in-service distributions” for specified purposes — such as paying children’s college tuition bills — if the distributions are set up properly through the plan.

Corporate tax deduction deferred. The company cannot expense compensation dollars that NQDCP participants contribute to the plan until the contributions are included in the employee’s gross income. Any earnings on deferred compensation are taxed to the corporation; however, they become deductible when paid to the participant.

Stiff penalties for premature withdrawal. If an employee opts to claim any accumulated funds before the normal retirement age (or other approved plan purpose), he or she can be subject to a 20% tax penalty, in addition to an income tax liability on the entire value of the deferred account — not just the amount of the withdrawal.

Risk of forfeiture. As noted, accumulated NQDCP benefits aren’t secured in a distinct trust for the benefit of plan participants, as they are in qualified plans. However, a commonly used vehicle known as a “rabbi trust” offers limited protection. Amounts assigned to that trust are no longer subject to alterations of the terms of the NQDCP by the employer, yet are still considered general corporate assets and subject to creditor claims in a bankruptcy.

Change in Control

Executive compensation plans typically feature change-in-control protections for covered executives, locking in certain pay features to secure promised benefits if the company is sold. NQDCPs typically have similar provisions.

However, these provisions can be troublesome to prospective purchasers of the company, knowing that their hands will be tied. A “double-trigger” change-in-control provision can alleviate that concern, providing, for example, that accrued benefits are guaranteed only for employees who leave within 18 months of the acquisition. That motivates the acquirer to give employees a chance to prove themselves before deciding whether to terminate them.

Is it Right for You?

NQDCPs are worth considering for employers seeking ways to give highly paid employees additional tools to save for retirement on a tax-deferred basis. Ask your benefits consultant or attorney about them. Because these plans are subject to strict regulations, it’s important to make sure that both your written plan and the operation of the plan comply with the regulations.

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