Employer Considerations for Nonqualified Deferred Compensation Plans
posted by Nathan Fisher January 7, 2020 Updated
Up to 69% of small business owners in a recent study said they aren’t confident in their ability to retire.1 In the same study, 68% said they’d feel a lot more confident if they were able to save more, but that isn’t always easy. In other words, as a small business owner, if you’ve ever felt unsure about your retirement, you’re not alone. But there’s a lot you can do beyond your company 401(k) plan to give you the ability to save more, like adding an Executive Deferred Compensation plan (also known as a nonqualified deferred compensation plan) to your retirement toolkit. Here’s how these powerful “top hat” plans work, and how you can set one up to stay on track for retirement.
401(k) Might Not Be Enough for Owners and Highly-Paid Executives
401(k) plans are the standard way for companies to help their employees save for retirement, and that includes owners. However, the rules governing 401(k) present a few potential issues that could cause higher paid employees, including owners, to not be able to save as much as they’d like in their accounts:
• Contribution Limits: As of 2020, participants in a 401(k) plan can only save $19,500 tax-deferred.2 If you happen to be over 50 years of age, you are also allowed an additional $6,500 in “catch up” contributions, which leaves your total possible savings at $26,000 per year—which might not be enough to keep up with your current lifestyle in retirement.
• Nondiscrimination Testing: Each year, all 401(k) plans must pass compliance tests to ensure that all employees participating in the plan are receiving a fair benefit. If rank-and-file employees aren’t saving enough as a group, it can reduce the amount higher paid employees (like owners) are allowed to save. So if, for example, you saved up to your $19,500 limit but your other employees saved much less, you may be forced to make “corrective distributions,” returning some of your 401(k) savings back to you. That means less money saved for the future—and increased tax liabilities in the short term, as you need to pay income taxes on any money returned.
What is Deferred Compensation?
Deferred compensation refers to a portion of an employee’s income they choose to collect at a date in the future. In the case of a 401(k) deferred compensation plan, for example, an employee elects to defer a portion of their compensation which is then deposited into a retirement account. This allows that money to be invested and grow tax-deferred until it is withdrawn in retirement.
What is a Nonqualified Deferred Compensation Plan?
In a nonqualified deferred compensation plan (NQDC), employees enter into an agreement with their employer to defer some of their compensation to a later date (such as retirement), at which point the employer agrees to pay them that amount. Used as a supplement to a 401(k), NQDC plans are an often overlooked tool for increasing retirement readiness among small business owners and other highly-paid employees.
The word “nonqualified” in a nonqualified deferred compensation plan indicates that the plan does not fall within ERISA guidelines. ERISA, also known as the Employee Retirement Income Security Act of 1974, is the set of rules that govern employer-sponsored defined contribution plans like a 401(k). As such, compensation can be deferred to any point in the future—maybe five or ten years—not just retirement. However, regardless of the date when the deferred compensation is paid out, the employee pays taxes on that money when receiving it, just like with a “qualified” deferred compensation plan.
What is a Top Hat Plan?
A “top hat” plan is a NQDC plan set up by companies specifically for highly paid executives to defer their bonuses in years when they already have a high tax bill. If small business owners set up top hat plans to defer any amount of their compensation—it might be a bonus, or a portion of salary, or some other incentive—they can defer paying taxes on that money now. In exchange, they’ll receive that money in retirement and pay taxes then, when they will likely be in a lower tax bracket and have a lower annual tax liability.
Types of Deferred Compensation Plans
Setting up a NQDC plan in one of these three common ways can help you save more of your compensation for retirement, while also giving your business a powerful new tool to reward top executives:
• Unfunded: In the most basic setup, the business puts forward no money from the start of the plan, which helps save in startup costs. Then, when the pre-determined time comes for the company to pay out the benefits to an employee, the money comes out of the firm’s operating cash flow at the time.
• Mutual Funds: Alternately, you could elect to invest a pool of money in mutual funds (and other investment options depending on the specifics of your plan) with the expressed purpose of growing assets to fund the paying out of NQDC benefits in the future. As a small business owner, this could help you grow your deferred money between now and your retirement. Additionally, this could help you set up a larger fund to offer NQDC benefits to other key executives, which could help you attract and retain important leaders for your company.
• Corporate Owned Life Insurance: Finally, some employers choose to use the deferred compensation they retain under a NQDC plan to pay premiums on corporate owned life insurance (COLI) policies covering the lives of key employees (like owners). In this setup, the company owns the policies, including the cash value and the death benefit. Companies can then use the benefits to recover any costs associated with the NQDC plan.3 Of course, the drawback here is that funds may not be immediately available to cover plan benefits when needed.
Are NQDC Plans a Good Option for You?
While NQDC plans offer business owners and other executives an attractive opportunity to lower taxes and save more for retirement, they aren’t for everybody. These plans are often complicated and come with a certain level of risk. Here are some key questions to ask to help evaluate if an NQDC plan makes sense for you:
1. Am I maximizing my contributions to my existing retirement accounts?
Qualified retirement plans like a 401(k) are a great way to save and grow your income for use in retirement. Because they are protected by ERISA, they offer a measure of security that nonqualified plans may lack. Are you contributing the maximum $19,500 to your account? If you’re eligible, are you also contributing your $5,500 catch-up? Beyond a 401(k), you can also look at HSAs and IRAs as additional measures to build up enough savings to maintain your lifestyle in retirement. If you are already maxing out each retirement account available to you but still want to save more, an NQDC could be a good fit.
2. Is my company 401(k) designed to help me save as much as possible?
You may be maxing out your individual contributions to your 401(k) plan, but not all 401(k) plans are made alike. For example, you might consider adding profit sharing to your existing 401(k) plan in order to reach your maximum total contribution limit of $57,000. If that’s not enough, cash balance plans are a special kind of qualified defined benefit plan that, when paired with a 401(k), can allow business owners to save as much as 4x more than a 401(k) plan alone. As you consider the benefits of a NQDC plan, also explore all of your options to increase your savings rates through your company 401(k) plan.
3. Will my business be able to fund my NQDC plan in the future?
In order to work, NQDC plans rely upon the company’s ability to pay out income in the future. If you choose to set up an unfunded NQDC plan, for example, your deferred compensation will eventually be paid out of your company’s operational cash flow. Your confidence in your business’ future financial situation may help you decide if an NQDC plan is a secure investment in your future, or more risk than you’re willing to take on.
Using Executive Deferred Compensation Plans to Increase Retirement Readiness
In the right circumstances, nonqualified deferred compensation plans for small businesses in conjunction with a 401(k) can give owners the power to save as much as they’d like for retirement. Plus, there’s the added benefit that NQDCs offer owners as a tool to help attract and retain the leadership talent they need. But NQDCs aren’t the only tool at your disposal to help with either of these challenges. Review the many plan options you have to customize your small business 401(k) plan to meet your unique needs.