Nonqualified Deferred Compensation Plans can be Valuable Tools as Income Tax Rates Rise
With higher income tax rates taking effect this year along with reduced itemized deductions and personal exemptions, individuals and couples in top income brackets are looking for ways to lessen their tax burden. Some are opting to defer income to a later date through a company benefit for highly compensated individuals.
A nonqualified deferred compensation plan, or NQDC, is a written agreement between a business and an executive of that business. Under the terms of this agreement, the business makes a contractual, unsecured promise to make future payments to those executives who participate, providing they meet certain stated requirements. By having these stated requirements in place (referred to as “golden handcuffs”), the executive is considered to have a “substantial risk of forfeiture” of that benefit. The requirements sometimes specify that the executive cannot leave and go to a competitor or that the executive must stay with the company for a certain number of years for the benefit to vest.
The agreement must comply with Internal Revenue Code Section 409A (nonqualified plans) and must be considered “unfunded.” As a formal requirement under this section, a NQDC plan is considered unfunded if any assets intended to pay promised benefits to an executive remain general assets of the business. This means that if the business goes bankrupt, its debts will be subject to its creditors first, and the executive’s promised benefits may never be paid out.
Although there are two types of well-known NQDC plans—supplemental executive retirement plans, also known as SERPs, and salary-deferral plans—businesses have a lot of flexibility in developing plans that suit their needs. One of the attractive features is that they can be customized for individual executives. NQDC plans also can be limited to a select group of management or highly compensated employees; because they are not considered to be “qualified” plans, they are not subject to the inclusiveness rules for qualified plans under the Employee Retirement Income Security Act, or ERISA. An additional benefit of these plans is that the business maintains control over who receives the benefits, not the government.
Tax Benefits for Executives
Under the terms of a nonqualified deferred compensation plan, as defined under Section 409A of the Internal Revenue Code, the following income tax benefits accrue to an executive:
- Since the plan is considered unfunded and the executive has a substantial risk of forfeiture (he or she may never receive their benefit from the plan), any compensation the executive defers until a later time is not considered compensation for the current year. For example, if an executive is entitled to compensation of $500,000 in 2013 but defers $150,000 of that amount through his NQDC plan, then his compensation for that year would be only $350,000 ($500,000-$150,000), not $500,000. The deferral may allow him to move out of the higher 39.6% federal income tax bracket and into the lower 33% tax bracket. The business will not be entitled to a tax deduction until the deferred compensation actually is paid out to the executive.
- When distributed to the executive, deferred compensation is not considered to be investment income and, therefore, is not subject to the 3.8% Medicare surtax that is charged on investment income.
- The triggering event for deferred compensation usually is the retirement of the executive. With him or her now in a lower tax bracket, any distributions taken from the plan would be taxed at a lower income tax rate.
Benefits to Businesses
A nonqualified deferred compensation plan provides many benefits to businesses, most notably the following:
- Helps retain and reward key executives.
- Helps recruit new key executives.
- Can be used to provide extra benefits solely for key executives because plans are not covered by non-discriminatory compliance rules of ERISA for qualified plans.
- Provides an income-tax deduction as a business expense when benefits are paid out to executives in the future.
- Provides “golden handcuffs” that require an executive to meet terms favorable to the business in order to receive the deferred income.
For more information about how these plans can benefit you or your company, contact your First Republic wealth management professional.
The views of the authors of these articles do not necessarily represent the views of First Republic Bank. First Republic Private Wealth Management encompasses First Republic Investment Management ("FRIM"), the Luminous Capital division of First Republic Investment Management, First Republic Trust Company ("FRTC"), First Republic Trust Company of Delaware LLC and First Republic Securities Company, LLC ("FRSC"), Member FINRA/SIPC. FRIM, FRSC and First Republic Trust Company of Delaware LLC are subsidiaries of First Republic Bank. FRTC is a separate division of First Republic Bank.
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