Employers are continuously looking for ways to enhance their ability to attract and retain top talent. This need will likely become more heightened as the economic recovery from the COVID-19 pandemic picks up steam and the labor market tightens.
Defined contribution and defined benefit plans play an important role in a company’s employee benefits offering, but many companies look for additional tools to enhance the total compensation package for key employees. Nonqualified deferred compensation (NQDC) plans are one such tool.
While NQDC plans are common among U.S. companies, some employers may not be aware of the many complexities NQDC plans entail or the high degree of flexibility they offer. Designing and implementing an NQDC plan to maximize its usefulness as a recruiting and retention tool requires understanding the unique compliance requirements and other nuances of these plans and communicating the risks and tax implications effectively to prospective and current employees.
Qualified vs. Nonqualified Retirement Plans
Employers offer NQDC plans primarily as a way for highly paid employees to save more for retirement in a tax-deferred manner beyond the limits of qualified defined contribution plans. For 2021, employees may contribute up to $19,500 to a 401(k) plan and the total employee and employer contribution limit is $58,000, plus an additional $6,500 for employees age 50 or older. These limits can make it difficult for highly compensated employees to reach the recommended 12% to 15% of pay that many financial planners recommend saving for retirement each year. Furthermore, the ability to defer pay to years when their income is lower can be very beneficial for employees looking to minimize their overall tax liability.
Employers can decide which employees are allowed to participate in an NQDC plan. Unlike qualified plans, NQDC plans impose no discrimination or other compliance tests, so employers don’t need to worry about the balance of highly compensated vs. non-highly compensated employees in the plan.
Employers have significant flexibility in structuring NQDC plans. These plans can be designed to provide the same investment options and matching contribution or vesting schedules as defined contribution or defined benefit plans—but they can also have radically different structures. Bonuses, in-kind benefits such as cars or homes, discounted stock, salaries and other types of incentive arrangements can all be deposited into an NQDC plan.
Potential Drawbacks of Nonqualified Plans
While the ability to defer income and taxes may seem appealing, NQDC plans have potential drawbacks that employers and employees should be aware of, including potential penalties and risk of loss.
In 2004, Congress added Section 409A to the Internal Revenue Code (IRC), partly as a result of the Enron scandal. Section 409A is intended to prevent executives from accessing funds in NQDC plans before the company goes bankrupt. Section 409A stipulates that an NQDC plan must have a written agreement outlining the amount deferred, as well as when and how it will be paid out. It imposes steep penalties if arrangements are violated. Specifically, violations result in deferred amounts becoming immediately taxable and also subject to a 20% penalty.
Unlike funds in qualified retirement plans, funds in NQDC plans are not protected from creditors. Employees who defer compensation may never recoup that money if the company goes bankrupt. This is because, by law, and from the standpoint of a creditor, the money is part of the company’s general assets until it is distributed to the employee. In general, employees cannot take the money out of the plan early or take loans against the assets (although there is some limited ability to access amounts in certain financial hardship circumstances).
From the employer’s perspective, it is important to realize that the company does not get to claim the corporate tax deduction for the deferred compensation until it is distributed to the employee. Also, rectifying mistakes made in administering NQDC plans is not as easy as doing so with qualified plans. Employers that make mistakes with their 401(k)s, such as late remittances or overpayments to accounts, can use the IRS Employee Plans Compliance Resolution System (EPCRS) to avoid penalties in many cases. While there is a correction program for NQDC plans, it is not nearly as flexible or favorable as EPCRS.
Explore All of Your Options
Companies considering an NQDC plan should realize that there are many decisions to make when designing a viable NQDC plan, including which employees will participate, how vesting or payout schedules will be determined and what amounts or types of compensation will be included. Just as important, for an NQDC plan to serve its role as a recruiting and retention tool, employers should ensure that prospective and current employees understand the details of the plan—including the potential tax benefits as well as the risks and limitations.
In addition, employers and employees should have a firm understanding of the Section 409A rules and consequences.
Employers looking for ways to allow certain employees to contribute more to their retirement savings than the IRS limits for qualified plans shouldn’t assume that NQDC plans are the best way to accomplish this goal. For example, cash balance plans—a type of defined benefit plan that has elements of a defined contribution plan—can be paired with a 401(k) and may be an attractive option for some companies.
Written by Beth Garner and Alex Lifson. Copyright © 2021 BDO USA, LLP. All rights reserved. www.bdo.com.