More midsize companies are seeking to do something extra for a select group of employees, usually executive-level staff.
Nonqualified deferred compensation plans, which are not subject to the Employee Retirement Income Security Act of 1974, have no discrimination restrictions, so employers can choose to whom they offer the plan. The plans also have no restrictions on deferral amounts, unlike qualified retirement plans.
“The economy has been getting a little better, and top talent is very valuable,” says John Carey, CPA, J.D., associate director of tax at SS&G. “Companies want to take that extra step to keep people and offer them an incentive to stay a little longer.”
At the same time, participating employees can defer income tax. Although they are performing the service now, the compensation is not subject to tax until they are actually paid, which might not be until they retire and are in a lower tax bracket.
“The tax environment has become more complicated, and tax rates have gone up,” Carey says. “You can have a rate of more than 40 percent in just federal income tax. People are looking to cut that — if they defer some of the income that would otherwise be taxable now, it gets them into a lower bracket and they are not subject to some of these extra add-on taxes.”
Smart Business spoke with Carey about what to consider when setting up nonqualified deferred compensation plans.
How do these types of plans work?
A nonqualified deferred compensation plan is a contractual obligation between the employer and employee to defer the receipt of compensation until a time in the future. IRS code section 409A governs these plans. They should be in writing and entered into before any services are performed that the compensation is based upon.
There are two types of nonqualified plans — elective and nonelective. With an elective plan, the company tells the employee, ‘You have the option to defer up to X amount of your annual salary.’ Under a nonelective plan, the company offers X dollars in the future in addition to the employee’s salary. It can be tied to performance criteria or remaining with the company for a certain time period.
The company decides which plan type to offer, often with employee input. It’s critical, however, to have good advisers discussing and planning out strategically what you want to put into the plan, what you want to accomplish with it, and what it can and cannot do.
How can employees get the most benefit from nonqualified deferred compensation?
Compare your current income with where you could be in the future when getting paid the deferred compensation. Do you project that it will be to your benefit due to being in a lower tax bracket in the future?
It’s also important to pay attention to the Social Security tax. The government imposes Social Security taxes on deferred compensation when there’s no longer a substantial risk of forfeiture, or when a benefit vests. Although income taxes are not imposed on the deferred amount until paid, with elective and certain nonelective plans the benefits may become taxable for Social Security. So, it’s better for both the employer and employee if the benefits vest in periods when the employee is making more than the Social Security wage limit, which is $117,000 in 2014.
Nonqualified deferred compensation plans have to be unfunded. What does that mean for plan sponsors and participants?
As an unfunded plan, it’s subject to the risk of the company’s creditors. Even if an employee did his or her job very well, if the business gets sued and goes bankrupt, nonqualified deferred compensation funds would be available to pay creditors. It’s a risk that plan participants take, so they need to consider the company’s stability.
Many companies use an informal funding method, such as a rabbi trust. The plan sponsor sets up a trust to put the money aside, and it cannot arbitrarily grab the money, but the funds are still general assets of the company so creditors can get at the funds.
Even with the risks, more executives today are asking companies to look at nonqualified deferred compensation plans, which are an incentive to retain and attract talent in today’s tax environment. ●
John Carey, CPA, J.D. is associate director of tax at SS&G. Reach him at (330) 668-9696 or [email protected].
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