As a seasoned industry veteran continues in a successful career, they may begin wondering about different alternatives for building a bigger nest egg. Over time, they may have accumulated a sizeable amount of money through a company-sponsored 401(k) plan, but at their current income, they may qualify for another type of savings vehicle called a nonqualified deferred compensation (NQDC) plan. This unique savings plan would allow such an individual to defer salary beyond the contribution limits of a qualified retirement plan, such as a 401(k) if they receive this benefit from their employer.
For starters, it is important to remember that this type of retirement plan is not for everyone. Unlike 401(k) plans that allow most employees at an organization to participate no matter their income level, in order to qualify for an NQDC plan, you must be a member of a select group of key management or a highly compensated employee, which the IRS generally defines as individuals earning $100,000 or more.
If an individual receives this benefit from their employer and is qualified to participate, they must sign the plan’s written agreement between themselves and their employer. Please keep in mind that a NQDC plan document must be prepared by outside legal counsel in compliance with IRS Code Section 509A. In this agreement, the employer would make an unsecured promise to defer part of the employee’s current compensation into an investment account. Keep in mind that this unsecured promise means that all contributions to the plan are considered the assets of the employer and could be subject to creditors of the employer.
After the written agreement has been signed, the employee would begin to defer a portion of their salary into investments chosen by their employer on a pretax basis. In addition to the salary deferrals by the employee, the employer can also make discretionary contributions for employees, which are not subject to current income taxes. It is important to note that the employee would not be subject to tax on income and realized capital gains generated by employer-owned NQDC plan assets, but their salary deferrals are subject to FICA and Medicare taxes.
An NQDC plan can offer many advantages. First, unlike traditional 401(k) plans that have a current annual contribution limit of up to $15,500 for 2007, NQDC plans are not capped until the employee reaches 100 percent of earned income. There are also no mandatory minimum withdrawal requirements at the age of 70-and-a-half and no penalties for distributions taken prior to age 59-and-a-half in an NQDC plan.
While the distributions from an NQDC plan may not be a concern for quite awhile, it is important to understand the options that will be available. Employees will be able to take plan distributions only under certain circumstances, including separation from service from their employer, disability, death, the passage of a specified amount of time, a change in the control of ownership at the firm where they are employed or an unforeseeable emergency. Employees may also be able to take accelerated distributions if their plan assets do not exceed $10,000 or in the event of a divorce. When one of these triggering events occurs, the balance of their account would be distributed as a lump sum or in installments, and the distributions are taxed as ordinary income.
If you are a business owner and desire to enhance the nest egg for highly compensated executives who contribute to the profitability of your business, an NQDC plan may be right for you. Contact your financial consultant for more information on the details of how these plans work and how they fit in with your businesses’ overall financial goals.
Darreld Hutchins is a CFP at A.G. Edwards & Sons Inc. in Vancouver. He can be reached at 360-693-1225 if you have any further questions.
