Q: John, briefly explain what a Non-Qualified Deferred Compensation (NQDC) Plan is and why business owners would be interested in one?
A: A Non-Qualified Deferred Compensation plan (sometimes called “Top Hat Plans”) is sponsored by an employer to provide additional retirement savings to recruit and retain its key employees. A NQDC must be unfunded. That is, the employee receives nothing more than the employer’s promise to pay benefits in the future (although the employer may decide to invest in an asset designed to match its future liability, as discussed below). This type of plan is not covered by ERISA and generally is easier to administer, having no discrimination testing, no minimum contributions and no Form 5500 filings. NQDC plans allow business owners to match or make contributions for their employees and defer the payout to a future date. The flexibility of the plans comes with one trade off; the employee’s claim to future benefits, including any of his or her own compensation deferred into the plan, could be wiped out or reduced in a bankruptcy or insolvency.
NQDC plans generally fall into two categories:
- Asset based, where the employer purchases an asset designed to match its future liability. Any employee deferrals and employer contributions are “invested” in this asset. The employer can give the employee the right to control how this asset is invested, similar to how a 401(k) plan would look. Any employer contributions can be tied to a custom vesting schedule. It is important to remember, however, that the asset is an employer asset and the employees in the plan have no specific rights in this asset. To match their liability, employers typically use cash on the company’s balance sheet, mutual funds / ETFs, or corporate owned life insurance (COLI), which can provide additional tax benefits to the employer.
- No-asset, where the employer simply accrues a liability to record the future benefits to be paid. Compensation can still be deferred and employer benefits can be promised. However, the employer does not have any asset on its balance sheet designed to match this liability. This form is generally not recommended or preferred by employees.
Q: What are the primary benefits of establishing a Non-Qualified Deferred Compensation Plan?
A: NQDC plans can help business owners attract and recruit top talent in a competitive, benefit-seeking environment where 401(k) profit sharing plans may not meet employee retirement goals. Providing these types of important retirement benefits may help retain talent and encourage company loyalty by helping employees meet their retirement goals. Companies can also put in place performance-based initiatives to reward employees while retaining “golden handcuffs” and providing a tool for mutual success.
NQDC plans are generally more flexible, even allowing an employee to defer up to 100% of their salary. They can provide employees with an ownership experience, while allowing for different timing on distributions and tax planning opportunities.
Q: How is a Non-Qualified Deferred Compensation Plan different than a 401(k) Plan?
A: 401(k) plans are protected under ERISA and have strict testing and filing requirements. This means 401(k) assets are invested in segregated accounts protected from company creditors. NQDC plans can step in and fill the gaps where key employees may be limited on contribution levels to their 401(k) plan. NQDC plans have no limits on contribution levels, can be distributed prior to age 59 ½ and provide employees, in some cases, a choice as to when to take distributions. 401(k)s are capped at IRS stated levels, and have rules around accessing funds prior to age 59 ½, which generally comes with an IRS imposed 10% early withdrawal penalty.
Q: Is it burdensome to establish and maintain a Non-Qualified Deferred Compensation Plan? What is involved?
A: Generally, NQDC plans are easier to administer, have lower costs, and require no testing compared to 401(k) plans. They can mimic 401(k) plans with most platforms and allow employees to change investment choices to match their specific retirement goals. Employees contributing to NQDC plans must make an irrevocable election decision to defer a specific percentage of their compensation from 0%-100%.
Q: Have there been any changes in approach to designing a Non-Qualified Deferred Compensation Plan in recent years that are worth sharing?
A: Corporate owned life insurance (COLI) was much more attractive a few years back due to the higher tax rates on corporations. With COLI, the business enjoys tax deferral when employees change their investment choices. There are no unwanted capital gains on corporate assets in COLI. However, due to lower corporate tax rates as a result of the 2018 calendar year tax law changes, companies should also look at mutual fund and ETF funding to compare the best method for funding future payouts.
Q: If you already have a Non-Qualified Deferred Compensation Plan, what are some best practices for reviewing and making potential improvements?
A: Investment choices, corporate owned insurance products and overall fees should all be part of a thorough review. With existing plans on the books, there may be ways to reduce fee “drag” and unwanted consequences. Also, life expectancy tables have increased. Meaning, life insurance policies purchased greater than 10 years ago may be able to be redesigned to allow for more efficient deferral of assets as life expectancy and insurance costs have become more competitive.
Q: How can Ancora help businesses and business owners with questions about Non-Qualified Deferred Compensation Plans?
A: Ancora has a very experienced team of professionals to help customize, review and design NQDC plans to match ownership’s goals. We can review integration and gaps with existing 401(k) plans. If you are a C Corporation, there are potentially very attractive tax benefits to explore with NQDC plans which we would be happy to discuss.