Building Retirement Income Through Deferred Compensation Plans
Many high-income earning business owners, executives, and professionals face limits on contributions to qualified retirement accounts, including 401(k) and 403(b) plans. These individuals may also be excluded from Roth IRAs and other accumulation plans because of income limits or plan requirements. Due to these limitations, high-income earners may find it difficult to accumulate the assets that they will need in order to retire on a significant percentage of their final income.
Non-Qualified Deferred Compensation Plans (NQDC)
Non-qualified deferred compensation plans emerged in response to the limits on employee contributions to government regulated qualified retirement savings plans. NQDC is compensation that has been earned by an employee, but not yet received from their employer. Therefore, it is not counted as taxable income until received.
Because high-income earners are unable to contribute the same proportional amounts to their qualified retirement savings, i.e. 401(k), as other earners, NQDC plans may provide a favorable solution to mitigate this difference. For example, if a business owner or professional earns $400,000 of annual income, their maximum 401(k) contribution of $19,500 is less than five percent of their annual income, making it difficult to accumulate an account balance, sizeable enough to provide a significant percentage of their income in retirement.
NQDC plans offer a way for high-income earners to defer income, avoid current income tax, and tax-defer investment growth. Because NQDC plans do not have the same restrictions as qualified plans, a participant can use their deferred income to achieve other objectives, including funding their children’s education. Investment options for NQDC contributions are selected by the participant and may be comparable to those offered in an employer sponsored 401(k) plan.
NQDC plans can accommodate employee only deferrals, employer contributions only, or both employee and employer contributions. Plans that include employer contributions are referred to as Supplemental Executive Retirement Plans (SERP). These plans can help employers attract and retain key employees. NQDC plans are exempt from most Employee Retirement Income Security ACT (ERISA) rules and reporting requirements, allowing employers to discriminate in favor of high-income earning employees, which is not permissible in qualified plans.
Additionally, employers can determine which employees are eligible to participate, establish a plan for one employee, set vesting schedules, and select investment options. There are no limitations on compensation amounts that can be deferred and no required minimum distribution rules.
Taxation of NQDC Plans
NQDC plans are regulated under Section 409A of the Internal Revenue Service code, which is relatively simple, when compared to the regulation of qualified retirement plans. Deferred compensation is includable by the employee in their taxable income when it becomes available to the employee. The employer reports the contributions and earnings as taxable compensation to the employee and takes a deduction when the employee includes the deferred amounts in their taxable income.
This is intended for educational purposes only and should not be construed as personalized financial or investment advice. Please consult your financial and investment professional(s) regarding your unique situation.