Today’s employers need to hire and retain good employees at all levels. However, some may struggle more than others to hang on to a certain kind of valuable staff member: leaders. Turnover at the executive level, or among other key employees, can paralyze an organization and hurt staff morale.
One way to incentivize leadership professionals to join your organization and stick with it is to offer fringe benefits beyond the usual variety. Nonqualified deferred compensation (NQDC) plans are a prime example.
Potential advantages
An NQDC plan is a legally enforceable agreement between an employer and an employee to defer part of the employee’s compensation to a future date, usually after retirement. The idea is to provide a later income stream for selected individuals on the condition that they remain employed with your organization.
For employers, NQDC plans can attract and retain top leadership talent. Many executives look for these types of arrangements when job hunting. Along with receiving the deferred compensation, plan participants won’t have to pay income taxes on it until they begin receiving distributions. And because most participants are retired by then, they’re often in a lower tax bracket.
Another positive attribute of NQDC plans is design flexibility. Because the plans are, by definition, not qualified (more on this below), they don’t have to comply with the rigorous requirements of the Employee Retirement Income Security Act.
This freedom allows you to craft a dynamic arrangement that not only financially benefits participants, but also helps you mitigate risks. For instance, you can include a noncompete clause or a condition that the individual will stay on as an advisor after retirement.
Key difference
When considering an NQDC plan, be sure to first understand the difference between qualified and nonqualified.
Under a qualified plan, so long as the employer follows various tax law requirements, contributions are deductible when made and payments to participants are guaranteed. A 401(k) is a type of qualified deferred compensation plan.
Under a nonqualified plan, participants rely on the employer’s promise to pay out the benefits on a specified date — but there are no guarantees. Participants run the risk that the organization might run out of money before any dollars are paid out.
This is because a key design component of most NQDC plans is that they’re “unfunded.” Under the agreement, the employer can’t set aside money to fund the plan. In exchange, as mentioned, participants will owe no tax on the deferred compensation until they receive it.
Distribution limits
Usually, employers intend to preserve tax deferral until payments are made to participants when they retire. That’s why it’s critical to work with your professional advisors to fully understand how current tax law and accompanying regulations apply to any NQDC plan design.
For example, certain restrictions apply to the timing of distributions. If a plan doesn’t meet the applicable requirements under Section 409A of the Internal Revenue Code, vested amounts of the deferred compensation could become subject to immediate taxation, a 20% penalty and interest. Generally, funds can’t be distributed before:
- Separation from service (plus an extra six months for key employees of publicly traded companies),
- Death or disability,
- A date specified by the participant at the time of deferral (or per a fixed schedule elected by the participant),
- A change in control (subject to IRS guidance), or
- The occurrence of an unforeseeable emergency.
Thus, subject to limited exceptions, NQDC plans can’t include what used to be called “haircut” provisions that allow participants to receive accelerated distributions in exchange for paying a penalty.
Complex arrangements
Make no mistake: NQDC plans are complex arrangements — and they should be. Each one must be written in a legally comprehensive manner to account for both parties’ rights and risks.
So, if you’re considering offering an NQDC plan, research the idea thoroughly. Should you decide to proceed, work closely with your professional advisors. We can assist you in evaluating the concept from a financial perspective by assessing the cash flow tax implications and other factors.
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