What is a Non Qualified Deferred Compensation Plan? These can also at times be referred to as a Supplemental Executive Retirement Plan.
Our early retirement strategy makes use of a Non-Qualified Deferred Compensation plan. These vehicles are widely available in large companies, but most employees don’t know about it until the day they get an eligibility letter in the mail. This is not meant to repeat what can already be found at Wikipedia – it is to give a high level overview and demonstrate how we will be using this in our early retirement.
These plans have a lot of flexibility in how they can be customized and the employer and plan sponsor customizes the plan. The starting point is what is the purpose? Will the plan be a Supplemental Benefit Plan or an Elective Deferral Plan (we have the Elective Deferral Plan)
The Supplemental Benefit Plan: Many companies will set non qualified plan as a supplemental vehicle for C-Suite Executives, Senior Management, and Top Revenue Producers. Contributions are from the company and the company is in control of the payout schedule. The company has some flexibility on if/how to fund these plans but it usually involves cash set aside and invested or the use of whole life insurance.
A real example from a former client of mine: The owners paid their leadership team a bonus in two parts – a cash bonus and a contribution to a non qualified plan. The goal was to reward top employees for tenure and keep them from leaving to a competitor. The money was contributed into a account and the employee could log in and look at it similar to a 401k balance. The employee chooses the investments for their portion of the funds.
The employee can access this money after age 55 and with five years of service. If the employee voluntarily left or terminated before vesting, the funds would revert back to the company. The company rewarded its top leaders for tenure with the company while providing a financial benefit greater than what a competitor would pay and increasing retention.
The Elective Deferral Plan: This plan is funded at the employees discretion with pre-tax contributions. This is what I participate in and here are the particulars of my plan.
Deferral options must be chosen by June 30th for the following calendar year. These can not be changed for any reason.
All contributions go into our 401k first, then once the maximum is achieved contributions then start flowing into the non qualified plan. The 401k match continues to be funded during each pay period
The plan has a 50% maximum contribution rate. The amount is not actually 50% because of the requirement to fully load the 401k first.
The employee must be protected to meet a minimum salary level in the upcoming year to contribute to the plan. At my employer this is based off salary plus incentive pay but excludes restricted stock awards. *
Our fund choices are nearly identical to the 401k. The plan login just has a drop-down box that lets you pick which account you want to see.
Distribution options:
– Installment payments starting 60 days from separation anywhere from two monthly payments to monthly payments for fifteen years
– Lump Sum paid 60 days after turning 65 (with an option for Feb of the following year)
-Installment payments paid for up to 180 months after turning 65
Once you pick a distribution option the payments cannot be accelerated. If you pick paid at 65 then you can’t turn around and choose to pay it out after separation. You can accelerate future year contributions to a faster payment schedule, but there are complicated wait period calculations involved.
What information I can’t figure out:
What is the distribution formula? I can tell there are flat monthly payments that reset annually. I can’t get an answer on if they will divide the current balance by the number of months remaining or if they imply an interest rate that will smooth out the payout.
What exactly are the tax implications coming out? I’m specifically interested in the state income tax and social security implications. Everything in the plan documents say “consult your tax adviser”
What does this amount to for for this early retiree?
I have been eligible for the plan since 2012 and contributed nice deferral percentages to it in 2014, 2017, 2018. I will still have some money spill over into the plan in early 2019 prior to departing. The expected balance is $260,000 at the point of early retirement.
So what is our distribution plan? We chose the fifteen year payout starting sixty days after separation.
Expected Monthly Payout: Somewhere between $1,444 to $2,450 with annual resets. If the plan pays based on dividing the principal balance by 180 months the payment will be lower in the beginning and increase with investment returns. If it pays based on implied rate then amount is more likely to be higher and flat. This will be just like a paycheck coming in and the plan will stop about three years before I start receiving any payouts from my pension.
So what are the downsides? (Hint: There are a bunch!)
Inflexibility. Ths IRS gives and the IRS takes away. In exchange for the pre-tax contributions and tax deferred growth, there are intense fences around these plans. You have to make your elections early and they can’t be changed during the year. You can’t change your distribution choices once they are made. For these reasons I wouldn’t recommend using a plan like this without a cash cushion on hand.
State Tax / FICA : The money going into this in my current state of Texas isn’t subject to state income tax. This also isn’t exposed to FICA since I still earn enough to fully contribute annually. I plan on moving after leaving my job and the withdrawals could be subject to state taxes and I can’t figure out if they’re exposed to FICA. The contributions that went in were above the FICA cap.
Corporate Solvency: This is the low probability but high loss possibility with these plans. As case law is currently written, assets inside a non-qualified plan can’t be touched by corporate management but are subject to claims as unsecured creditors in a bankruptcy. This means employees would be pooled with the claims of other creditors and a judge decides which creditors get which money. You should understand your company or organization’s financial position and risk of bankruptcy prior to contributing to the plan.
What does understanding solvency risk look like? Consider how often do companies in your industry go bankrupt. If you work for a private company, do they have any debt? How are troubled companies in your industry usually resolved? In my case I work in a highly regulated industry and companies are usually sold prior to failure. In the rare instances of failures there have still been a takeover and the plan has been protected.
Should you consider participating in a Non Qualified Plan?
What is your state tax situation going to be in retirement? If you’re planning on staying in the same state or moving between states with income taxes, this is a non-issue. If you plan on moving from a high income tax state to a no income tax state, will you still be challenged for payment of state taxes? If you’re planning on moving from a high tax state to a low tax state, be aware that some states have a history of challenging state taxation for distributions. New York has a history of going after Florida retirees for state taxes on deferred compensation pay.
If you’re in a state with no income tax and plan on moving to a state with income taxes, some of the savings may be negated. This may be the case with 75% of our contributions.
Are the automatic deductions valuable to you? This is forced savings and helps us. After all the deductions my paycheck is only 40% of my gross pay. This is a huge benefit for us – we can’t spend what we don’t have. I compare this to contestants on survivor loosing weight. Want to loose weight? Go somewhere there’s no food. The same applies to saving money if we starve our inflow.
Does this help you meet the Roth IRA limits? We’ve gone in and out of the Roth IRA limits for a few years. We have been eligible again due to some advanced planning. (Yes, there’s the backdoor Roth but this is easier)
Does a steady “paycheck” after leaving your job appeal to you? It did for us. This will be one account constantly feeding our bank account as if we were working.
So did we make the right choice? To Be Determined
I’m fortunate to work in a highly regulated industry (banking) with a track record of transferring these plans to the buyer even in the event of bankruptcy.
I’ve enjoyed the forced savings and the ability to put away funds before tax when I’m earning at a high marginal tax rate. The recent tax reform plan didn’t change the math at all because the state and local tax limitations will offset the lower rates.
The idea of regular paycheck is appealing and getting that income paid at a zero/10%/12% federal income tax rate instead of 24% is a great deak.
The challenges that are still to be determined: I have less liquidity than I would have if I had paid the taxes earlier. I also deferred a portion of this in a state with no income taxes and am now paying income taxes on distributions. The funds are not liquid and accessible for investment opportunities. If I end up finding a hobby that earns income or go back to work, the tax advantages at distribution disappear.
Do you have access to a Non Qualified Plan or any other questions? Please ask in the comments below or reach out to me.
The first time I saw this was because the company accidentally send an email to the every eligible employee without using blind carbon copy. All people who made over a certain salary level could see whether their peers were above or below this. This was during the same time period where discussing salary was a fire able offense at my company. I saw the list when an older employee from another department asked me “if I knew anything about this”? I was surprised at who did/didn’t earn the cutoff.
