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How Non-Qualified Deferred Compensation Plans Work

Dana Anspach, president and founder of Sensible Money, explains the ins and outs of non-qualified deferred compensation plans.

Do you work for an employer that offers you a non-qualified deferred compensation plan (NQDC)? What is it? How does it work? Should you use it?

“In simple terms, it is a plan that allows you to take part of your salary or bonus, and avoid paying taxes on it today by tucking it away in a plan that has special rules as to when and how you can take it back out,” said Dana Anspach, president and founder of Sensible Money.

That sounds relatively easy to understand, she said in an interview.

But there are several types of non-qualified deferred comp arrangements and the rules for each type are slightly different. “In addition, each plan can offer certain options and those differ from plan to plan,” she said.

The first thing to learn is whether the deferred compensation plan is a 457 plan or a 409A plan?

According to Anspach, 457 plans are offered by a state or local government and work much like a 401(k). Another type of 457 plan can be offered by a non-government tax-exempt entity and that type has a different set of rules.

The 409A plan, which is what Anspach sees most often with her firm’s clients, is a deferred compensation plan offered by for-profit companies. “We see them offered by big public companies like Microsoft, large private companies and by partnerships or smaller private entities such as law firms and medical practices,” she said.

And when it comes to 409A plans, plan participants often require unique solutions.

A case in point was one of Anspach’s clients, an attorney who was a partner in a large practice. “During his working years, each year he could elect to defer a portion of his salary into the deferred comp plan,” she said.

And when you do this, you have to make the election to defer a portion of your compensation before the year starts. “So, if you have access to a deferred comp plan, in the fall of this year, you'd be making an election as to what percentage of your salary or bonus you want to contribute to the plan the following year,” Anspach said. “Once you make the election, you can't change your mind for that year.”

And the following year you can again choose to participate or change the amount but once you elect for the year, you’re locked in. “This is far different than a 401(k) where you can go in and change your contribution amount or stop or start it at any time,” said Anspach.

Multiple distribution election options

At the time you make a contribution election, you also make a distribution election. “That means you choose now when and how the funds will be paid out to you,” said Anspach.

For example, you may choose a payout at termination, or some plans allow you to pick a specific year. You can often designate the funds to be paid out as a lump sum or in installment payments such as over five, 10 or 15 years, she said.

“In the attorney's case his election specified his deferred comp was to payout over five years the year after he terminated,” said Anspach. “And, because he was self-employed - a partner in the law firm - he owed not only income taxes but also FICA taxes - both the employee and employer share on the amounts received.”

Now if you are an employee, most of the time you pay the FICA taxes at the time you make the deferral, and then when the funds come out, you only pay income tax on the distributed amount, she said.

What to Consider When Structuring Distributions from a 409A

“Electing your deferrals to be tax-efficient is an area where we see the most room for improvement,” said Anspach. “Many participants don't understand the rules and may randomly select times for the funds to be paid out. When we go to project their retirement income it sometimes means a giant lump sum right at termination when there could have been a way to structure it that fit with other items in their plan.”

Indeed, there’s much to consider when structuring distributions from a 409A.

A case in point is one of Anspach’s clients, an employee of a large technology company who has been contributing to NQDC since 2015. “Every year, he makes two elections, one for a portion of his salary, one for a portion of his bonus,” she said. “Some of those elections were randomly scheduled to payout as a lump sum, some at termination, one in 2032, and one in 2050. Other elections were scheduled to pay out over five years, and some over 10 years.”

Given all the payouts, Anspach had to create a custom schedule to estimate the impact of when these distributions would hit his tax return. “Then, going forward, she recommended all election options to be paid out in installments over 15 years starting at termination,” she said. “We also recommended he change some of his previous elections, so he didn’t encounter a tax bomb the year he retires.”

Of course, one of the not so well-known rules about 409A plans is this. When you change elections, you also have to move the start date out at least five years. “So, you can't move a payout up in time - only defer it to begin at least five years from your previous date,” said Anspach. “And if the date is unknown, such as ‘at termination’ then when you change it, it will be five years after whatever your termination date ends up being.”

What’s more, you must make any changes at least 12 months prior to what the payout date would have been and often at least 12 months prior to termination, she said.

Tax Hits and Sequence Risk

There are some other hidden risks with 409A plans, as well.

A case in point is a distribution election plan Anspach recently did for a highly compensated employee of a privately held company. This client had his deferred compensation plan set to pay out as a lump sum at retirement, which would have created about $1.5 million of taxable income for him that year, she said.

And addition to a big tax hit, taking a lump-sum distribution creates sequence risk. “All the investments in the plan will be cashed in on a single date in the future,” said Anspach. “That's a lot riding on a single day. If you have a huge liquidity event like that, you need to adjust your investments accordingly.”

In this case, Anspach recommended that the client defer the distribution another five years and have it paid out over five years. “This spreads the tax liability out over years where his rate will be lower, and also reduces his risk of having to cash it all in during a big market downturn,” she said.

Deferred Comp Plans are Unfunded Liabilities of a Company

This strategy, however, prolongs a different type of risk, said Anspach. “Deferred comp plans are unfunded liabilities of a company,” she said. “Should his company go belly up, his deferred comp payout could be at risk. In his case, he felt completely confident in the future of his company and decided stretching out the tax liability and reducing exposure to sequence risk was the right choice. But there are cases where someone may feel safer taking it all out as soon as possible.”

But these are things you have to work through on a case-by-case basis, said Anspach.

Other items to consider: Before you fund your NQDC, consider fully funding first your health savings account (HSA) and then your 401(k). “And when choosing investments for your NQDC, coordinate the investments based on the timing of when you need the money,” said Anspach.

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