This is a re-edit of a write-up I posted a months earlier at
Boggleheads.
We have a few people in our company who currently max out their 401K contributions. What options are available for those who want to shelter even more income? After getting some quick pointers, I started dwelving into Non-Qualified Deferred Compensation (NQDC)
plans. After reading through dense IRS regulations to
supplement summary info found on the web, this is my best understanding
of NQDC plans for for-profit
organizations. (Government agencies and non-church tax-exempts are
covered by 457 plans and have somewhat different rules.)
Advantages
No limits to income deferral
No restrictions on discrimination
Can withdraw money before age 59 1/2
Disadvantages
Strict guidelines on contribution and withdrawal schedules
Dividends, capital gains can be taxable to sponsoring company
Tax-deferred contributions not protected from creditors in case of bankruptcy
Heavy penalties for not following regulations
Contributions
Unlike qualified plans, the employer cannot take a deduction for contributions to a NQDC
plan whether it's employee money or matching employer dollars. FICA,
FUTA, payroll taxes are owed on contributions but income tax for the
employee is deferred.
Plan participants must decide their NQDC
contribution amounts and schedule the tax year before compensation is
earned and must be done within 30 days of eligibility. Changes to
contribution amounts/schedule must be done 12 months in advance of any
changes.
Withdrawals
Withdrawal amounts and schedule must be selected by plan participants
at the same time the contribution amounts/schedule is decided. The
first withdrawal must be at least 2 1/2 months after the last tax year
contributions are made. So if an employee contributes NQDC
money anytime from January to December 2008, the earliest a withdrawal
can happen is on March 15, 2009. Withdrawal schedules must be fixed
dates and cannot be triggered by events. Withdrawal schedules can be:
- lump sum
- lump sum purchase of SPIA (the full amount immediately taxable for employee)
- arbitrary amounts or percentages at arbitrary dates
- fixed amounts or percentage of plan assets per period
- annuitized schedule
Delaying a withdrawal schedule must be done 12 months before the
first withdrawal date and any delay must be at least 5 years later than
the original withdrawal date. Accelerating withdrawal schedules is not
allowed except in cases of:
- separation of service
- death
- disability
- divorce order
- unforeseen financial emergency
- change in company control.
If you do not specify a withdrawal schedule, you may only take a lumpsum distribution after one of the above exception events.
Upon withdrawal, a sponsoring company that invests plan assets into
mutual funds would realize capital gains (where there's a profit). The
employer can then take the withdrawn amount as a deduction. The
employee will owe income tax on the amount but not FICA, FUTA or
payroll tax. If the employee no longer lives in the same state as when
he earned the compensation, he can avoid paying tax to that state as
long as the withdrawals are taken out equally over a period of 10 years
or longer.
Deviating from the contribution & withdrawal guidelines will
reclassify all deferred income as paid out the year compensation was
earned with a 20% penalty plus interest. (In short, don't do it.)
Plan Types
There are mutiple NQDC
plan types but the one most straightforward is a Rabbi Trust
with plan funds invested in mutual funds. In a Rabbi Trust, NQDC
contributions are generally protected except for company insolvency. In
this case, plan funds are considered company assets against claims by
creditors with plan participants listed amongst the pool of creditors.
In exchange, the IRS allows NQDC
contributions to be tax deferred for participants. (A Secular Trust
protects against bankruptcy but does not offer tax deferred
contributions.) The IRS allows individuals to purchase bankruptcy
insurance for their funds but it cannot be a company-sponsored
activity.
With a for-profit organization, plan funds invested in mutual funds
can generate taxable dividends and capital gains for the company. A
church with tax-exempt status effectively creates a tax-deferred plan
using a Rabbi Trust.
The 70% exemption rule for qualified dividends paid to
corporations introduces an interesting twist for company owners
investing in a NQDC
plan. Ordinarily, a taxable account should hold low dividend yield, low
turnover to minimize tax drag. But a participant with vested interest
in company finances should invest in funds paying out high amounts of
qualified dividends. This reduces the amount of capital gains to the
corporation at withdrawal leading to a larger deduction offset.
It is possible to create a tax-deferred plan using
cash value life insurance but it requires the company pay insurance
premiums until the participant dies to then collect on the death
benefit tax free to offset participant withdrawals. The long-term
planning makes this an inappropriate choice for all but large
companies.
How to setup a plan
1) Have corporate attorney write legal documents to setup a Rabbi Trust (otherwise known as a grantor trust)
2) Write plan documentation describing all the rules
3) Open an Investment Only (FBO or Pooled) account with Vanguard Small Business
4) Enroll participants and start deferring income
This is my best understanding of NQDC
plans. I am not an accountant or a lawyer so please check with your tax/legal/benefit consultants first. Most of this research was
done because our health plan broker tossed out a line about using cash
value insurance to fund a non-qualified retirement plan. That
immediately set off some warning bells for me to understand more about
this subject instead of simply accepting his product offering. If
anybody sees any errors or oversights in what I've just posted, please
don't hesitate to comment.
Use or don't use
Since the time I did this research and writeup, we've been looking at the books left and right and decided a non-qualified plan was not appropriate for us. The major problem is the corporate taxes on deferred compensation. At profits above 75K, the taxes range from 43%-47% (fed + CA) -- ouch! As more and more employees participate, the cost effective cap per employee decreases. So at this point, this idea is shelved ...
(Filed in retirement plans)
Beyond the 401K: Non-Qualified Deferred Compensation
Posted by Mossy
May 9, 2008 6:00 AM
We have a few people in our company who currently max out their 401K contributions. What options are available for those who want to shelter even more income? After getting some quick pointers, I started dwelving into Non-Qualified Deferred Compensation (NQDC) plans. After reading through dense IRS regulations to supplement summary info found on the web, this is my best understanding of NQDC plans for for-profit organizations. (Government agencies and non-church tax-exempts are covered by 457 plans and have somewhat different rules.)
Advantages
No limits to income deferral
No restrictions on discrimination
Can withdraw money before age 59 1/2
Disadvantages
Strict guidelines on contribution and withdrawal schedules
Dividends, capital gains can be taxable to sponsoring company
Tax-deferred contributions not protected from creditors in case of bankruptcy
Heavy penalties for not following regulations
Contributions
Unlike qualified plans, the employer cannot take a deduction for contributions to a NQDC plan whether it's employee money or matching employer dollars. FICA, FUTA, payroll taxes are owed on contributions but income tax for the employee is deferred.
Plan participants must decide their NQDC contribution amounts and schedule the tax year before compensation is earned and must be done within 30 days of eligibility. Changes to contribution amounts/schedule must be done 12 months in advance of any changes.
Withdrawals
Withdrawal amounts and schedule must be selected by plan participants at the same time the contribution amounts/schedule is decided. The first withdrawal must be at least 2 1/2 months after the last tax year contributions are made. So if an employee contributes NQDC money anytime from January to December 2008, the earliest a withdrawal can happen is on March 15, 2009. Withdrawal schedules must be fixed dates and cannot be triggered by events. Withdrawal schedules can be:
- lump sum
- lump sum purchase of SPIA (the full amount immediately taxable for employee)
- arbitrary amounts or percentages at arbitrary dates
- fixed amounts or percentage of plan assets per period
- annuitized schedule
Delaying a withdrawal schedule must be done 12 months before the first withdrawal date and any delay must be at least 5 years later than the original withdrawal date. Accelerating withdrawal schedules is not allowed except in cases of:- separation of service
- death
- disability
- divorce order
- unforeseen financial emergency
- change in company control.
If you do not specify a withdrawal schedule, you may only take a lumpsum distribution after one of the above exception events.Upon withdrawal, a sponsoring company that invests plan assets into mutual funds would realize capital gains (where there's a profit). The employer can then take the withdrawn amount as a deduction. The employee will owe income tax on the amount but not FICA, FUTA or payroll tax. If the employee no longer lives in the same state as when he earned the compensation, he can avoid paying tax to that state as long as the withdrawals are taken out equally over a period of 10 years or longer.
Deviating from the contribution & withdrawal guidelines will reclassify all deferred income as paid out the year compensation was earned with a 20% penalty plus interest. (In short, don't do it.)
Plan Types
There are mutiple NQDC plan types but the one most straightforward is a Rabbi Trust with plan funds invested in mutual funds. In a Rabbi Trust, NQDC contributions are generally protected except for company insolvency. In this case, plan funds are considered company assets against claims by creditors with plan participants listed amongst the pool of creditors. In exchange, the IRS allows NQDC contributions to be tax deferred for participants. (A Secular Trust protects against bankruptcy but does not offer tax deferred contributions.) The IRS allows individuals to purchase bankruptcy insurance for their funds but it cannot be a company-sponsored activity.
With a for-profit organization, plan funds invested in mutual funds can generate taxable dividends and capital gains for the company. A church with tax-exempt status effectively creates a tax-deferred plan using a Rabbi Trust.
The 70% exemption rule for qualified dividends paid to corporations introduces an interesting twist for company owners investing in a NQDC plan. Ordinarily, a taxable account should hold low dividend yield, low turnover to minimize tax drag. But a participant with vested interest in company finances should invest in funds paying out high amounts of qualified dividends. This reduces the amount of capital gains to the corporation at withdrawal leading to a larger deduction offset.
It is possible to create a tax-deferred plan using cash value life insurance but it requires the company pay insurance premiums until the participant dies to then collect on the death benefit tax free to offset participant withdrawals. The long-term planning makes this an inappropriate choice for all but large companies.
How to setup a plan
1) Have corporate attorney write legal documents to setup a Rabbi Trust (otherwise known as a grantor trust)
2) Write plan documentation describing all the rules
3) Open an Investment Only (FBO or Pooled) account with Vanguard Small Business
4) Enroll participants and start deferring income
This is my best understanding of NQDC plans. I am not an accountant or a lawyer so please check with your tax/legal/benefit consultants first. Most of this research was done because our health plan broker tossed out a line about using cash value insurance to fund a non-qualified retirement plan. That immediately set off some warning bells for me to understand more about this subject instead of simply accepting his product offering. If anybody sees any errors or oversights in what I've just posted, please don't hesitate to comment.
Use or don't use
Since the time I did this research and writeup, we've been looking at the books left and right and decided a non-qualified plan was not appropriate for us. The major problem is the corporate taxes on deferred compensation. At profits above 75K, the taxes range from 43%-47% (fed + CA) -- ouch! As more and more employees participate, the cost effective cap per employee decreases. So at this point, this idea is shelved ...
(Filed in retirement plans)
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