Employer Considerations for Nonqualified Deferred Compensation Plans
posted by Nathan Fisher November 11, 2020 Updated
Company-sponsored retirement plans can help employers reach their business goals while helping employees prepare for a dignified retirement. But the more employees make, the smaller percentage of their total earnings are able to be saved in a traditional 401(k) plan. That means executives might not be able to save as much as they’d like for retirement, but it also presents employers with an opportunity to offer creative benefits that can help them compete for high-performing leadership.
In some circumstances, Nonqualified Deferred Compensation (NQDC) plans can help high earners save more for retirement. Here’s why these executive deferred compensation plans might be worth considering—and how they work to help employers keep their 401(k) plans working well while offering a special benefit to key employees.
401(k) Might Not Be Enough for Highly Paid Executives
401(k) plans are the standard way for companies to help their employees save for retirement. However, the rules governing 401(k) present a few potential issues that could cause higher paid employees to not be able to save as much as they’d like in their accounts:
• Contribution Limits: As of 2021, participants in a 401(k) plan can only save $19,500 tax-deferred.1 If an individual happens to be over 50 years of age, you are also allowed an additional $6,500 in “catch up” contributions, which leaves the total possible savings at $26,000 per year—which might not be enough for highly paid employees to maintain their current lifestyle in retirement.
• Non-discrimination Testing: 401(k) plans undergo compliance tests designed to see that employees participating in the plan are receiving a fair benefit. If lower-paid employees aren’t saving enough as a group, it can reduce the amount employees who make over $120,000 per year are allowed to save. So if, for example, a high earner saved up to their $19,500 limit but your other employees saved much less, you may be forced to make “corrective distributions,” returning some of your highly paid employees’ 401(k) savings back to them. That means less money saved for the future—and increased tax liabilities in the short term, as employees 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.
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 the business sets up top hat plans to allow high earners to delay 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.
Are NQDC Plans a Good Option for You?
While NQDC plans offer 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 your business:
1. Is my company set up to maintain an NQDC plan?2
On the most basic level, executive deferred compensation plans are a good fit for businesses set up as any of the following:
• Public companies
• Privately held C corporations
• Pass-through entities such as S corporations, LLCs, and partnerships
• Non-governmental, tax-exempt organizations
Additionally, you’ll want to have confidence that your business is well-established, profitable, and prepared to manage and fund NQDC plans into the future. Typically, that means businesses that have good cash flow and have either grown or remained stable for at least five years. These plans work well with companies with strong revenue of $10 million or more annually and a well-documented business continuation strategy.
2. Does my company have several executives failing to save enough for retirement?2
If your company has more than 100 employees and 10 or more executives earning more than $150,000 per year, an NQDC plan might be a good fit for you. This is especially true if your highly paid employees are 50 years old or older—and if you find yourself having to regularly issue corrective distributions. Those refunds mean increased tax liability for key employees now, and less money saved and invested to fund retirement later.
3. Is my business struggling to hire or keep executive talent?2
Especially in a tight labor market, businesses need to pull out all the stops to appeal to the skilled, experienced employees they need. If you’ve found that it’s difficult to land your top executive candidates—or keep the employees you already have—with the compensation and benefits package you are already offering, top hat plans can allow you to offer an often-overlooked tax management benefit while making perks like signing bonuses and incentive programs even more attractive.
4. Is my company 401(k) designed to help executives save as much as possible?
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. For example, you might consider adding profit sharing to your existing 401(k) plan in order to help key employees reach their maximum total contribution limit of $58,000.
Using Executive Deferred Compensation Plans to Attract and Retain Employees
In the right circumstances, nonqualified deferred compensation plans for small businesses in conjunction with a 401(k) can help employers attract and retain the leadership talent they need. But NQDCs aren’t the only tool at your disposal to help with that challenge. Review the many plan options you have to customize your small business 401(k) plan to meet your unique needs.
2 Principal Financial Group report: “Nonqualified Deferred Compensation Plans: Plan Designs That Drive Business Success”