Deferred Compensation: Strategies for HCE's

A nonqualified deferred compensation plan, also known as NQDC, is a type of agreement between an employer and an employee. It enables the employee to postpone receiving income that they have earned currently. These plans are distinct from other qualified retirement plans that the company may offer and have their own set of regulations and guidelines. In this post, we will be taking a look into Deferred Compensation plan; defining what they are and how they operate, then discussing how Highly Compensated Employees may utilize them to complement their retirement plan and tax strategies.

Click to expand the following lists:

1. How do deferred compensation plans differ from qualified retirement plans?

   A qualified retirement plan enables the employer to claim a tax deduction immediately for the contributions made to the plan. The employer benefits from the tax deduction and the employee will only be subject to taxes when they withdraw money from the plan. However, to qualify for a qualified plan, one must adhere to strict compliance and IRS regulations. The plan must cover a significant portion of employees, and there are limitations on the contributions made by the owner and other highly compensated employees. These restrictions lead some companies to use deferred compensation plans as an additional employee benefit option to incentivize their Highly Compensated Employees. A deferred compensation plan can be structured to allow a tax deferral to the company while avoiding most of the burdensome requirements of ERISA. There are no funding limits applied to deferred compensation plans, although compensation must be reasonable to be tax-deductible. You can also provide benefits to certain employees without including all company employees, even at the lower levels.

2. What is the difference between a funded versus unfunded deferred compensation plan?

   A funded deferred compensation plan is a plan in which assets are set aside and invested to provide for the future benefit payments to the employee. The assets are held in trust and managed by a third party, such as a bank or insurance company. The employee has a legally binding right to the assets set aside for their benefit, and they are protected in the event of the employer's financial difficulties. An unfunded deferred compensation plan, on the other hand, is a plan in which no assets are set aside to provide for the future benefit payments to the employee. Instead, the employer promises to pay the employee a certain amount of money at a future date, but no assets are set aside for that purpose. The employee has no legal right to the assets set aside for their benefit, and they are not protected in the event of the employer's financial difficulties. In general, funded deferred compensation plans provide a higher level of security for the employee because the assets are set aside and invested, while unfunded deferred compensation plans rely on the employer's ability to pay the benefits in the future.

3. Deferred Compensation Income Tax Issues

   In general, contributions to a deferred compensation plan cannot be claimed as a tax deduction by the corporation until the employees are taxed on them. This could occur several years later. Employees do not typically include contributions to an unfunded deferred compensation plan or any related earnings in their taxable income until the benefits are received. However, the taxation of funded deferred compensation plans is more intricate. As soon as they vest, employees typically include contributions in taxable income. The taxation of plan earnings will depend on the plan's structure. In some cases, employees will include earnings in their current taxable income, but under certain conditions, they are not taxed until they receive payments from the plan.  Click the 'I have multiple Deferred Comp distribution options, how do I choose' for more details on tax issues. 

4. How do I factor in deferred comp with my retirement plan?

   Deferred compensation plans usually offer a limited number of investment options selected by the employer, while 401(k) plans usually offer a wider range of investment options selected by the employee. After initial setup, many HCE's can keep their deferred compensation plans 'out of sight out of mind'. This can be a costly error in planning. Set up a time with us as your advisor to review your deferred comp plan annually and make sure the investment selections are complimenting your risk tolerance and future income goals.

5. I have multiple Deferred Comp distribution options, how do I choose?

   Deferred compensation plans do not have mandatory minimum distributions. Depending on the options of your plan, you typically have the choice of receiving your deferred compensation either in a lump sum or in installments. Let's take a look at each option. Lump-sum distributions: Opting for a lump sum allows you to access all your deferred compensation at once, at the time of the distributable event, often at retirement or separation from service. This could be beneficial if you do not want your former employer to have control over your deferred compensation. Once you receive the lump sum, you have the freedom to reinvest it as you see fit, free from the restrictions of the NQDC plan. However, you will owe regular income tax on the entire lump sum at the time of distribution, which can result in a larger tax bill than installment distributions, and push you into a higher tax bracket. Additionally, you lose the benefits of tax-deferred compounding when withdrawing the money from the plan. Installment Distributions: With an installment plan, you receive smaller distributions over a specified period, typically yearly, quarterly, or monthly. The remainder of your deferred compensation stays in the account, where it can continue to grow tax-deferred. Spreading the distributions over several years can lower your overall tax bill, especially if your personal income tax rate decreases. However, you must be comfortable being an unsecured creditor of the company if you choose this option. In some cases, you may also have the option of taking a special state tax benefit if payments are made over 10 years or more. Payments structured this way are taxed in the state of residence when paid, not in the state where the income was earned. This is a tax advantage for those planning to move to a state with lower income tax rates. You must also plan your distributions around other sources of income, such as mandatory minimum IRA withdrawals, to meet your cash flow needs and tax situation. Regardless of the form of distribution you choose, it's crucial to consider the timing of the distributions in relation to other company benefits, such as restricted stock vesting and stock option exercises, as well as income from other retirement plans.  

6. My deferred comp plan allows 'in service' distributions...what is that?

   Some NQDC (Non-Qualified Deferred Compensation) plans allow for "in-service" distributions to be scheduled for specific dates, offering a tax-advantaged way to save for short- and mid-term goals. The "class-year" approach, also known as laddering, involves scheduling distributions for specific years, such as a child's education or retirement, with separate accounts and investment portfolios for each year. Depending on the plan, payments can be structured as installment payments or lump-sum payments to reduce tax liability. Scheduling in-service distributions requires more planning but can partially mitigate the risk of company default and potentially reduce income tax liability.

7. Other considerations:

   No matter which distribution strategies you choose, it's difficult to change the schedule once you've created it. A subsequent distribution election, if allowed by the plan, cannot permit the payment to be paid earlier than originally elected except in cases of extreme hardship, death, or disability—so you can’t simply change your mind and ask for your deferred compensation a year or two earlier than your scheduled distribution date.

In summary, deferred compensation plans are an excellent benefit for highly compensated employees, as they provide a tax-advantaged way to save for retirement. By deferring a portion of their income, employees can reduce their taxable income in the current year and potentially lower their tax burden. Over time, the deferred compensation can grow tax-free, resulting in a larger retirement income for the employee. Partnering with a financial advisor can add even more value for those participating in a deferred compensation plan. An advisor can help employees determine the best distribution strategy based on their personal goals, tax situation, and overall financial plan. They can also provide guidance on investment options and help manage the plan to ensure it aligns with the employee's long-term financial objectives.

If this Acorns article has caused you to ponder if your current deferred compensation strategies are sound, we’d enjoy the opportunity to analyze it for you.  Our priority is making sure you have confidence in the process.  We would love to hear your thoughts on these points and hope you’ll reach out to us for further discussion.