Employers looking for ways to attract and retain key talent can enhance their retirement plans with a nonqualified deferred compensation plan (NQDC).
NQDC plans can solve for shortfalls in savings for highly compensated employees and provide retirement preparedness equity to those who have already maxed out their qualified plans limits. They do this by helping these individuals save beyond the limitations imposed by the IRS on qualified plans.
At the same time, employers can use NQDC plans to recruit, reward, and retain top talent, while minimizing the impact to the company’s financials. These plans offer employers:
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Increased flexibility: NQDC plans are not qualified, which means the employer does not need to follow Employee Retirement Income Security Act (ERISA) requirements. This allows more plan flexibility and customization tailored to the company.
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Additional cash flow: Since NQDC plans “postpone” employee compensation until a predetermined time in the future, they free up company cash that can be used to cover short-term business needs.1
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Minimal set up and administration costs: After legal and accounting fees have been paid, NQDC plans do not involve additional annual costs or require government agency filings.2
Asset options for NQDC funding
While any asset can be used to finance a NQDC plan, the most prevalent and commonly used funding vehicles are cash, mutual funds, and corporate-owned life insurance (COLI).
Before an employer selects how to fund their NQDC plan, it’s important to realize that these are still company assets. So, whether they're sitting at the company, in a brokerage account, or in a Rabbi trust, any tax issues or consequences that occur when owning these assets are the company’s responsibility.
Below are the advantages and disadvantages of some commonly used funding options:
Cash (also known as “Unfunded”)
Depending on the size of the company, it may make sense for the employer to keep the cash normally paid to a participant—an “employee pay-as-you-go” scenario. This option can increase company cash flow, allowing the employer to put away money until the employee is paid in the future.
Before an employer chooses to establish an unfunded NQDC plan, however, it’s important to evaluate the primary disadvantages:
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Compounding liabilities: Unfunded liabilities can be substantial, and the company must financially prepare for this undertaking. If, for example, a company experiences an unexpected loss in revenue or assets, it may result in a perpetual state of “catch up” to replenish the NQDC plan. This could ultimately impact the key employees receiving these benefits in the future—with the potential for them to receive less deferred compensation than the amount agreed to in the plan.
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Active and consistent management: Companies must ensure that the accounting for the unfunded plan is actively managed and meticulously tracked. Deferred compensation shows up on the company’s balance sheet as a liability and must be reconciled consistently each time a payout is made.
Mutual funds
Mutual funds are another common way to fund a NQDC plan. Simplicity is the biggest draw for employers choosing this option—setting up and administering a NQDC plan with mutual funds can be easier than when using other funding methods. Mutual funds offer other advantages, too, including:
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Account flexibility: When selecting mutual funds as the funding vehicle for a NQDC plan, employers have maximum flexibility and customization. For example, some choose to mirror their company wide 401(k) plan, while others deliver more customized offerings for executives and key employees. Either way, the choice is up to the employer.
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Low-cost investment options: This type of NQDC plan offers additional funds and exchange-traded funds that are available on the platform. Most offer institutional pricing, depending on the size of the purchaser, which provides plan participants lower fund expenses and fees in comparison to the standard retail pricing.
The major disadvantage when using mutual funds as the funding asset is the tax consequence. In fact, every time participants reallocate their portfolios, the company will need to pay taxes on any gains if they’re engaged in the contract. And any distributions from the mutual funds, whether interest or capital gains distributions, will result in a company tax leakage.
COLI
COLI is permanent life insurance that’s owned and realized on the company’s books, insuring the lives of its select participants. Like other life insurance policies, COLI’s tax advantages make it an attractive way to fund NQDC plans. More specifically, a COLI offers:
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Tax-deferred cash value growth: Cash values within the policy grow on a tax-deferred basis, which means that the employer does not need to set up a deferred tax liability—as long as the company plans on holding the policy until the individual’s death.
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Tax-free death benefit: The policy’s death claim on its key employees is delivered to the company income tax-free. Many employers use this tax-free death claim to recover the costs associated with paying for the NQDC plan.
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Tax-advantaged reallocation: An employer that uses a variable universal life (VUL) policy to fund their NQDC plan can reallocate the cash value inside the policy on a tax-free basis. Unlike mutual funds—which are taxed on any capital gains when a share is sold—the funds within the life insurance policy won’t generate additional tax costs when the employer wants to rebalance the portfolio.
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Tax-advantaged access: The employer can participate in tax-free withdrawals, up to the premium dollars paid into the policy, within certain limits determined by the IRS. In addition, the employer can also take policy loans on a tax-free basis—as long as they’re repaid—which means a company does not need to wait until a key employee’s death to use proceeds.
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Selection of competitive investments: COLI offers a variety of investment options into which the employer can choose to invest the policy cash value.
But like all asset vehicles, there are some disadvantages to using a COLI to fund a NQDC plan:
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Cost of insurance (COI): The cost of insurance, or the fees associated with certain types of life insurance products, can create a drag on the policy’s returns.
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Even so, an employer that’s comfortable sacrificing some of the cash value returns would still be able to avoid paying tax costs with COLI.
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Complexity: These types of funding assets aren’t as simple as mutual funds.
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However, if a company is willing to take on a little more complexity, it may be worth enjoying the tax advantages that accompany a COLI policy, depending on the employer’s overall financial objectives.
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How a NQDC Plan Works
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The employee elects to defer a portion of compensation and the employer withholds this amount each pay period. The employer may make matching/discretionary contributions as additional incentives.
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The employer may invest the deferred compensation in cash, mutual funds, or a life insurance policy on the life of the employee. With COLI, the employer owns the policy and is named the beneficiary.
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At the payment triggering event, the employee receives the benefit payment (deferred compensation balance plus any asset growth). The payment is generally tax-deductible to the employer and taxable to the employee.
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COLI: Policy loans and withdrawals will generally not be taxable. Upon death of the insured, the employer receives the policy death benefit, income tax-free.
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Mutual funds: Upon liquidation, the employer pays taxes on any realized gains not previously taxed.
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Cash: Payments will be made from the employer’s working capital.
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Considerations before implementing a
NQDC plan
Business owners that may benefit from a NQDC plan should work through the following five-step strategy before implementing it into their businesses:
Step 1:
Ask the following questions:
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“Do you want to attract and retain key employees?”
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If the answer is yes, “Is a NQDC plan the right fit for the business?”
Step 2:
Work with a trusted M Financial professional that understands how a NQDC plan, and the assets used to finance it, work.
Step 3:
Choose a plan that fits the business’ goals, objectives, and company culture.
Step 4:
Determine how the company will fund the plan.
Step 5:
Once the plan is implemented, ensure that a record-keeper can provide the employer and plan participants the information needed to manage the account.
A NQDC plan—funded with cash, mutual funds or COLI—can be an advantageous benefit that helps an organization recruit, reward, and retain valued employees who will advance the company’s vision and business objectives. By adding it to highly compensated individuals’ benefits packages, an employer can successfully leverage company assets while providing this flexible, cost-effective, and high-value benefit to its key employees.
Contributors:
1 Employers, however, will need to have the cash available for distributions down the road.
2 NQDC plans must follow IRC Section 409A regulations, and many employers use professional administration services to meet these requirements.
All examples provided are for illustrative purposes only and are not intended to serve as investment advice since strategy is dependent upon your individual facts and circumstances.
This material is intended for informational purposes only and should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney, tax advisor or plan provider.
This material is intended for informational purposes only and should not be construed as legal or tax advice and is not intended to replace the advice of a qualified attorney, tax advisor or plan provider.
Investments in securities involve risks, including the possible loss of principal. When redeemed, shares may be worth more or less than their original value. Investors should consider the investment objectives, risks, charges and expenses of any investment carefully before investing.
Nonqualified benefits are contractual obligations of the employer; plan participants are unsecured general creditors.
An insurance contract's financial guarantees are subject to the claims-paying ability of the issuing insurance company.
Cash value accumulation is determined by the policy contract, is not always guaranteed, and is subject to withdrawals.
Cash values and death benefits may vary based on the policy you purchased. Please consult your full policy illustration at the time of purchase.
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